Inventory Fraud: What Manufacturer's Should Know-明升体育app下载

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 inventory accounts 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 and/or inventory accounting records, providing an ongoing opportunity to steal or manipulate the books.

Inventory fraud impacts both the balance sheet and the income statement and can be perpetrated in more than one way, such as actual theft, manipulating inventory counts, improper valuation of inventory, scrapping perfectly good inventory, and simply making a fraudulent journal entry, to name a few. As it impacts the income statement, the ramifications can carry over to the next year as well.

Inventory Fraud Example

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 fraudsters 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.

What Makes Inventory Vulnerable to Fraud?

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)
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 first-in, first-out (FIFO), deploying actual, average, or standard costing methods as well as activity based or absorption estimates and last-in, first-out (LIFO)

The more complicated a company’s inventory reporting process, the more opportunities employees may have to commit fraud.

Employee Motives and Methods for Inventory Fraud

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

For example, personal financial pressures or 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, underappreciated or overworked by an owner who is wealthy or who takes frequent vacations.

The risks associated with inventory fraud are dependent upon the nature of the industry. For example, an inventory of small diamonds is harder to control than an inventory of bulldozers. This puts a unique perspective on how each company should customize controls related to inventory. Strong, well-designed controls are the best preventative measures relating to fraud.

Whatever their motives, employees use a variety of techniques to steal inventory. The most obvious is directly taking items for personal use or resale.

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, excess, 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, bonuses criteria, and other metrics.

How to Prevent Inventory Fraud

Below are some recommended procedures to put in place to prevent fraud, but please note this is not an exhaustive list.

Preventive controls:

Physical controls are the first prevention tool for theft. Ensure inventory is kept at a secure location and only authorized access is permitted. Is it gated, locked and access restricted to authorized personnel? 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. Security cameras have the ability to see what is going in and out of the warehouse when you can’t be there. Just knowing they are there can be an effective deterrent for employees.

Ensure there are adequate segregation of duties between purchase authorizations, custody of the inventory, and recording the related accounting activities. For example, the employee in charge of production should not be in charge of shipping. Who can input purchase orders? Who authorizes inventory purchases? Who can edit inventory records?

Accounting information systems – Invest and fully utilize perpetual inventory systems to maintain inventory quantities and costs. Many small business do not maintain inventory accurately between reporting periods and rely on annual detective controls to true-up balances.

Detective controls:

Perform analytical review procedures to compare what is recorded to prior years’ and current year’s actual activity. Specifically, review the amount recorded for inventory to the amount of cost of goods sold. Compare increases in inventory to increases in sales. If sales are declining, inventory should be fluctuating accordingly. How much inventory capacity does your company have compared to what your books reflect is on hand? Analyze the inventory recorded to the required square footage needed to store it. Compute inventory turnover and compare to prior periods. Analytical procedures are some of our favorite auditing tools as they are quick to perform but can speak volumes.

As an example of analyzing reasonableness, there was an instance at a restaurant in Tennessee in the early 2000’s. The restaurant was “hopping” during the day. It was full of customers, and business seemed great. The inventory being recorded as used was also in line with the restaurant’s capacity and the actual observation of the customers dining. However, after a few weeks it was noted the sales seemed low. The customers were there and the inventory was declining accordingly, but the sales recorded did not correlate. After investigating it was brought to light that the manager on duty had asked the servers to bring him the tickets for the customers, and he would process their payments. Instead, of processing the payments, he was voiding the tickets and pocketing the cash.

Analyze the valuation of inventory – Review the inventory listing to determine if the quantity on hand and the unit price for each inventory item look reasonable. Scan the listing for anomalies. Make periodic comparisons to invoices for the inventory purchase to determine if the cost recorded is reasonable. Compare the cost of the inventory to prior periods or for the past three years. Has an allowance been made for scrap, obsolete, unsalable, or slow-moving items? Is the allowance reasonable based on what is on hand, and as a percentage of sales? If you have multiple locations, obtain a printout of inventory housed at each location and analyze to determine if it is reasonable.

Perform and observe physical inventory counts – Inventory counts can be conducted via cycle counts, perpetual counts or a complete “wall to wall” count on a periodic or annual basis. Compare the results of the physical count to what is recorded in the general ledger. Oftentimes, the external auditors can be utilized to observe the physical inventory counts and to perform test counts.

Regarding the inventory counts, be sure to perform forward and backwards test counts. This entails selecting inventory items on hand and locating where they are recorded on the inventory listing. Then select items on the inventory listing and find them in the warehouse, store, etc.

Performing surprise inventory counts, even if performed on just a few select items, can be effective. This should be performed at nonstandard inventory times, such as the middle of the month, weekends, early in the morning or at 3 a.m.

Review manual journal entries booked to the inventory general ledger account. Analyze the write-offs and determine how they impact the Profit and Loss statement. Are the journal entries supported with appropriate documentation and approvals? Take a “high level” view to determine if the entry makes sense.

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.

Inventory fraud is a pressing concern for manufacturers due to the complexity of inventory accounting and the potential for employee misconduct. To safeguard your manufacturing business, implement robust internal controls, enhance security measures, and conduct regular audits. Learn more about our specialized services for the manufacturing industry to protect your assets and secure your financial future.

Inventory Fraud Example

What Makes Inventory Vulnerable to Fraud?

Employee Motives and Methods for Inventory Fraud

How to Prevent Inventory Fraud

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