Inventory Fraud: Knowledge Is Your First Line of Defense

Inventory is one of the biggest assets on a manufacturer’s balance sheet. It’s also one of the hardest assets to measure and track. Thousands of transactions flow through the inventory account each year — and many of these journal entries require subjective estimates, such as overhead allocations, write-offs and valuation adjustments. In addition, many employees have direct daily access to inventory or inventory accounting records, providing an ongoing temptation to steal or cook the books.

Consider ABC Manufacturing, a fictitious company that fell victim to a $300,000 inventory fraud scheme involving three trusted employees. Their scam was simple: The shipping clerk sent most finished goods to legitimate customers or company-owned retail outlets. But a few shipments to retail outlets were redirected to the home of the payables clerk. Later, the controller picked up the stolen goods to resell them on the Internet.

ABC’s retail outlets weren’t invoiced for shipments at the time of delivery. So there was no paper trail identifying what had happened to the redirected shipments. Without physical inventory counts, the perps were able to pull the wool over the owner’s eyes for more than 18 months. Eventually, the shipping clerk became overwhelmed with guilt and confessed the scheme to the owner. With stronger internal controls, the scheme might have been detected sooner — or prevented from ever occurring.

Inventory is vulnerable to fraud because it’s eventually closed out to cost of goods sold (COGS). This is an expense account that winds up as part of retained earnings at the end of the accounting period. The formulas for computing COGS are:

Beginning inventory + purchases = goods available for sale

Goods available for sale – ending inventory = COGS

These formulas make sense for retailers or distributors that don’t add value to the goods they ship and, therefore, handle only finished goods. But they’re oversimplified for manufacturers that process raw materials into finished goods.

Manufacturers typically possess three types of inventories: finished goods, work-in-progress (WIP), and raw materials. WIP inventories include charges for raw materials, direct labor and overhead. Sometimes there are additional charges when the production of components is outsourced to a third party or another division of the company.

In addition, manufacturers can use a variety of techniques to account for finished goods inventories under Generally Accepted Accounting Principles. These include the lower of cost or market; first-in, first-out (FIFO); and last-in, first-out (LIFO). The more complicated a company’s inventory reporting process, the more opportunities employees have to commit fraud.

Small manufacturers often operate like families. Owners can’t fathom that a trusted “family member” would ever steal inventory. But it happens more often than you might think. When faced with a financial pressure and given an opportunity to steal, an employee may rationalize the theft of inventory.

For example, personal financial pressures or an addiction may entice an employee to steal inventory or overstate it — especially if he or she discovers a weakness in the internal accounting policies and procedures. The employee may rationalize the theft because he or she feels underpaid, under-appreciated or overworked by an owner who takes frequent vacations.

Whatever their motives, employees use a variety of techniques to steal inventory. The most obvious is directly taking items for personal use or resale. Physical controls are the best prevention tools here. To illustrate, warehouses should have a limited number of doors with 24-hour surveillance inside and outside of the facilities, including dumpsters, trucks, foliage and parking lots.

Inventory fraud may also occur within the accounting department. For example, the controller or CFO may try to overstate inventory by artificially inflating inventory counts or values, recording false entries into the general ledger, or failing to write off old, obsolete or damaged items. Moreover, the inventory account may become a “slush fund” for other internal fraud schemes. Inventory overstatements might be used to manage earnings or to meet financial covenants.

Unearthing financial misstatements involving inventory overstatements is less straightforward than catching people who directly steal physical assets. A forensic accountant can help you by benchmarking financial statement trends, verifying source documents and building a case that will help you prosecute fraudsters in your midst.

Global research company IBISWorld recently published its annual list of America’s riskiest industries for 2014 and 2015. Several types of U.S. manufacturers made the top 10 list, including apparel, computer, vacuum and small appliance, cigarette and tobacco, and recordable media manufacturers. Most of these have been in a state of decline due to changing consumer trends, overseas production and technological advances.

Managers in these sectors may feel intense pressure to meet stakeholder expectations, which could drive them to commit fraud to hide weak financial performance. If you operate in a declining market segment, regularly assess your fraud risks and talk to your financial advisors about ways to mitigate your vulnerability to financial misstatement and theft by employees.