| Summer 2005 |
Manufacturing/Distribution Advisor
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Is Your Inventory Walking Out the Door?
United States companies lose an average of 6 percent of their total
revenue to fraud by their own employees - a form of theft that costs
$400 billion every year, far more than armed robbery.
The usual suspects - aren't. Stereotypes notwithstanding, the typical
perpetrator is a college-educated white male. And while rank-and-file employee
fraud involves more people, losses from managerial fraud are four times higher,
and those from executive fraud are 16 times higher.
Employees who commit fraud rationalize the crime in several ways: It's
only fair. Everybody else does it. No one will know. I'll repay it eventually.
Some schemes are planned long in advance, by trusted employees whose position
has acquainted them with a company's operations or brought them close to its
suppliers and other key partners. Others arise ad hoc, aimed at
low-hanging fruit made tempting by a company's own lax oversight.
Poor screening of new hires, failure to document disciplinary actions,
inconsistent personnel policies, neglecting to inform employees about internal
controls - these are all invitations to fraud. And internal controls, if they
are insufficient or easily neutralized - or sometimes even too consistent
- aren't much help.
The Caper Unfolds in Stages
Fraud schemes often begin with an intentional "accident" or anonymous
small-scale theft. These are simply tests, designed to illuminate the terrain
and provoke a company's response for evaluation by the fraud planner. Then the
plan develops, most often targeting one of the following areas:
- Accounts Payable can deliver kited or forged checks, kickbacks,
rigged bids, transfers to fictitious payees and even paychecks to ghost
employees.
- Accounts Receivable can permit lapping - the ongoing replacement of
stolen receipts with subsequent thefts.
- Expense accounts can hide inflated - or invented - costs for
travel, entertainment, supplies or seminars.
- Inventory is vulnerable to direct theft, diversion, overstatement,
understatement, quality substitution, false weights and measures, short
shipments or false valuation.
After the crime, a means of escape may be needed - depending on the chances
of detection. If discovery is unlikely, perpetrators lie low; otherwise, they
resign before the game is up.
Inventory Fraud by Rank-and-File Employees . . .
Production processes that involve complex accounting systems, numerous
employees and large volumes of product make inventory fraud particularly
difficult to detect and prevent. The most attractive inventory is either small
and portable, very valuable, or easy to sell.
Common inventory fraud by employees includes direct theft, good inventory
scrapped and sold, sales refund schemes, unauthorized outbound shipments and
manipulation to conceal other frauds.
. . . And by Management
In manufacturing and retail, the largest expense for most firms is usually
cost of goods sold. A dishonest manager may try to inflate inventory in order to
misrepresent operational performance and earnings.
To do so, managers must manipulate either physical quantities or the values
associated with them. And the means of doing so - empty boxes in a warehouse,
bricks packaged as computer parts, tags altered after a count, multiple counts
of the same items, rigged barter transactions and bulk sales - are limited only
by imagination.
But understatement of inventory can serve a purpose, too. Minimizing
stock-on-hand can be attractive to business owners who want to evade taxes or
minimize their assets in anticipation of penalties arising from business or
personal legal proceedings.
Detecting Inventory Fraud
The basic tools for uncovering inventory fraud are tests for quantities,
compilation and valuation.
- Testing quantities by physical count. In normal times a company may
employ various means to validate its inventory, including cycle counts or
continuous updates, but a fraud investigation often requires a full physical
count.
In these circumstances the company should consider contracting out
inventory services - a CPA firm like ours can organize a count efficiently,
accurately, with a minimum of notice and with its own count team (which, of
course, won't include the fraud perpetrators).
In any case, investigators must carefully guard the integrity of the
count - performing it outside the view of employees, if possible, and with
strict controls over count sheets and tags, used or unused. The counters
should examine inventory contents, with tests for purity and grade if
appropriate - a lesson that creditors in one bankruptcy learned a bit late,
when they discovered an oil tank filled 90 percent with water, a meager layer
of fuel floating on top. And the counters should inspect records for goods
received and shipped near the date of the inventory to see if they were
properly included.
- Testing inventory compilation. Opportunities for manipulation arise
between the counting and pricing of inventory, particularly when counts of the
same items at various locations are aggregated into one list. An effective
investigation requires inspection not just of the final list, but of every
iteration that preceded it.
- Testing inventory valuation.
Investigators should confirm that vendor invoices support the stated value of
inventory on hand. If a company uses dollar-value, last-in first-out (LIFO)
accounting, investigators should be alert to the manipulation of LIFO pools to
inflate ending inventory. In an average-cost system, slow-moving items deserve
particular scrutiny, which may require purchase and sales documents from
several years.
Improperly valued items demand an explanation. Investigators should
learn why they exist - and not be deterred by evasive responses or complex
pricing formulas.
Next Steps
A manufacturing or distribution company, whose core business isn't policing
or investigating, may need help when it faces the costly and complex challenges
of inventory fraud. Fortunately, such help is readily available - from
consultants and specialists like those at our firm, who are trained in
company-wide risk assessment, computerized models for detecting suspicious
patterns, physical inventory counts and financial statement analysis.
Some early warning signs of inventory fraud include:
- Unexpected shortages or fluctuations in inventory accounts
- Large adjustments to counts after a physical inventory
- Significant increases in cost of goods sold
- Significant decreases in gross margins
- Unusual or late journal entries
Objective analysis can expose these symptoms. Three ratios in particular -
age of inventory, gross profit margins and inventory turnover - are revealing
and should be calculated in detail regularly and in different quarters. However,
these symptoms don't necessarily indicate fraud, because inventory is an
area that's particularly susceptible to faulty record-keeping.
Editor's Note: Bober, Markey, Fedorovich
& Company frequently works with clients on matters such as
this. Please call your partner / manager contact if you would like assistance in this area.
Manufacturing/Distribution Advisor is produced quarterly by Bober, Markey, Fedorovich & Company's
Manufacturing/Distribution
Services Team. If you would like additional information about the services that we can provide to manufacturers and wholesale distributors, please call or email our team leader, James E. Merklin, CPA, M.Acc. at (330) 762-9785 or
jimm@bobermarkey.com.
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