Error or Theft? Understanding Inventory Fraud.

July 12, 2023

Protecting your company’s inventory involves guarding against physical theft and monitoring inventory record-keeping.

A company’s inventory is often one of the largest assets on its balance sheet. Unfortunately, inventory doesn’t always receive the careful monitoring it deserves – often at the expense of a company’s bottom line. In this article, we’ll look at physical inventory theft and inventory accounting fraud and ways to protect your company.

Physical Inventory Theft

Whether you deal with raw materials, parts, supplies, or finished goods, it’s common to find small discrepancies between your inventory on hand and the information in your system. These discrepancies may come from everyday factors like damage, clerical error, or delayed data entry, but they may also result from employee inventory fraud. For many companies, an inventory shortage that exceeds 2% is cause for concern.

Know Your Risk 

The risk for inventory fraud varies by industry, type of inventory, company size, and other factors. Retailers, manufacturers, and contractors that stock parts and materials often face the highest risk. Theft is especially common among companies with high-value inventory such as electronics, jewelry, brand-name merchandise, or items that can be easily resold. Also, if your inventory recording process is especially complex, this may create an opportunity for a dishonest employee to cover up theft or bury another kind of accounting fraud.

Prevent Discrepancies

Habitual or systematic inventory theft can go unnoticed for many months. Sometimes the discovery of theft is only by chance or because of a glaring accounting disparity. Clearly defined protocols can help you detect theft earlier or prevent it altogether and can also help reduce losses due to carelessness. Train your employees on the proper way to stock, transport, price, and record inventory, and make sure the handling of damaged, defective, or lost items is consistent. Conducting spot checks and monthly inventory counts can help you catch and correct errors before they cause major problems.

Get Outside Help

Hiring an outside team to perform an inventory count on a regular basis, such as once a month or once per quarter, can help you keep a clear picture of your inventory and improve your reporting. While third-party counts add a new recurring cost, the resulting improvements to your inventory process and reduced losses can more than make up for this expense.

Set Up Controls

While background checks and references can help you find trustworthy employees, it’s still important to have safeguards in place to deter and catch employee fraud. Physical controls, like video surveillance and secured access points, are often crucial. Making sure employees carefully record warehouse activity and inventory movement can also maintain accountability. Because manipulating your inventory system can happen in the absence of physical theft, it’s important to have inventory accounting controls that are rigorous as those for cash management.

Fraudulent Inventory Accounting

Protecting your company’s inventory involves more than just guarding against physical theft. While setting up controls to prevent physical inventory theft is important, it’s just as crucial to monitor and implement controls for your company’s inventory record-keeping. If your company is a retailer, manufacturer, or other inventory-based business, taking steps to prevent fraudulent inventory accounting is a must.

Why It Happens

This type of fraud commonly hides inventory theft, but covering up an inventory disparity isn’t the only motive for this crime. Dishonest management or accounting staff may manipulate inventory records in order to disguise or fund another scheme, such as reporting fictitious sales, skimming funds, tax fraud, or overstating earnings to deceive lenders or stakeholders.

How It Happens

The way a dishonest employee commits inventory fraud depends on the scheme being committed and the individual’s access to the inventory system. Common methods include:

  • Falsifying inventory counts or inflating values
  • Failing to report new inventory
  • Completing phony write-offs
  • Failing to write off inventory when needed
  • Changing existing entries

Looking into possible fraud in your inventory system isn’t as straightforward as investigating regular theft. A midsize company may see thousands of entries in its perpetual inventory system each year, and these transactions sometimes include subjective estimates that make it harder to detect fraud than in other types of accounting. Also, when numerous employees are involved in the reporting process, whether directly or indirectly, it can be difficult to pinpoint the source of suspicious activity.

Strengthening Controls

Middle-market executives can follow these steps to boost transparency, accountability, and accuracy in their company’s inventory management:

  • Require secondary authorization for entries with insufficient information
  • Use a third-party service for periodic inventory counts (see above)
  • Maintain a strict authorization policy for write-offs and other inventory updates
  • Create a clearer separation of duties to increase accountability
  • Regularly match your cost of goods sold (COGS) to sales data, your shipments to sales invoices, and supplier deliveries to inventory counts

Investigating Possible Fraud

Routine changes, such as overhead allocations, inventory value adjustments, and write-offs of lost, damaged, or obsolete inventory, make it hard to distinguish ordinary fluctuations from deliberate manipulation. Because investigating inventory fraud is a complex process, consider hiring an expert such as a forensic accountant to review and verify inventory documentation and collect the evidence needed to put a stop to this crime.

Here to Help

If you need assistance managing your business finances, reach out ENB.