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If Your Inventory is Shrinking, Could It Be Due to Inventory Fraud?

Jennifer French discusses inventory fraud

If Your Inventory is Shrinking, Could It Be Due to Fraud?

Jennifer French CPA, CGMA, Principal

For the second installment in my series of fraud articles, I’ve selected to focus on inventory fraud.  For some reason, fraud relating to inventory doesn’t seem to grab the attention of headlines quite the same as other fraud schemes.  However, during my research, I noted it to be one of the most interesting fraud segments and one that multiple articles could be drafted on.  My approach is one at a high level, but I may delve deeper in a future article based on how well this article is received 

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.

The risks associated with inventory fraud is dependent upon the nature of the industry. I remember attending a training early in my career and the instructor discussing inventory and its inherent susceptibility to fraud.  He stated if you own a diamond mine, it is easy for workers to slip a couple of diamonds in their pockets when leaving for the day.  Since a diamond is small in size, it is harder to control verses if you have an inventory of bulldozers.  This puts a unique perspective on how each company should customize controls related to inventory. As we hear over and over, proper controls are the best preventative measures relating to fraud.

In keeping with the precedence set with the initial fraud article I drafted, I wanted to note some actual instances of inventory fraud, both historical and recent, that have made the news.

One of the early instances of fraud was in the 1800s and is known as the Poyais Fraud.  General Gregor MacGregor served in the British army which required him to travel to Central America.  Upon his return to London, he announced the new nation of the Republic of Poyais.  He had crafted a constitution, created currency and claimed it was a developed colony.  He then proceeded to sell off land to investors and potential settlers in London.  When the first group of settlers arrived at the so called Republic of Poyais, they found nothing but dense jungles. Approximately 250 settlers ended up traveling there and half of them perished.  To this day it remains unclear how much money he earned from the fraud.  He was tried in 1826, and what is surprising is that some of his victims came to his defense claiming his associates had failed him.  As a result, the court acquitted him.  This may not be the typical inventory fraud scheme as it dealt with land, but thought it interesting enough to share.

McKesson & Robbins was a drug and chemical maker exposed in 1938 for numerous fraud schemes, including overstatement of inventory.  The fraud was engineered by Phillip Musica, alias Frank Donald Coster, the president of the company.  It was discovered that $10 million of inventory recorded on the books was nonexistent.  The underlying cause for the perpetration of fraud was the company, as most others at the time, was experiencing the effects of the recession.  He committed suicide before he could be arrested. This fraud let to major auditing reforms.  Supposedly, this is one of the cases that indirectly led to the creation of the Generally Accepted Auditing Standards that we are required to adhere to.  It is still known to this day as the fraud that changed auditing forever.

In the early 1990’s, Laribee Wire Manufacturing Corporation was a copper-wire manufacturer whose business suffered when the construction industry experienced a decline.  Laribee had pledged its inventory as collateral in order to obtain $130 million in loans from six banks.  However, the pledged inventory was either nonexistent or the inventory on hand was recorded on the books at an amount that far exceeded its value.  Additionally, shipments between its plants was recorded as inventory at each of the plants.

A local instance of inventory fraud happened in May 2016, regarding the Kate Spade Outlet at The Outlet Shoppes of the Bluegrass.  The Kate Spade store was storing inventory in a vacant store, and a maintenance worker had the keys.  Per local news reports, purses were being taken from storage and sold to individuals and pawn shops in a nearby city.  Approximately $17,000 worth of pursers were recovered. I was unable to find a reference to the amount of inventory that was lost.

In order for your company to not make the headlines for inventory fraud, the following suggested controls and procedures can be implemented as preventive measures relating to inventory fraud. Also, note that these are not all inclusive as there are other options to consider in addition to these.

Adequate segregation of duties – 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? 

Performance of analytical procedures – 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 my favorite auditing tools as they are quick to perform, but speak volumes.

In regards to analyzing reasonableness, there was an instance at a restaurant in Tennessee back 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 this a little further, it was brought to light that the manager on duty had asked the waitresses 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 in order 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.

When I perform an inventory observation, I request the inventory listing in multiple formats.  I review a printout sorted by the highest total amount of a product or item on hand.  Another printout reviewed is one sorted by the highest unit cost to the lowest unit cost.  Lastly, one that I also request is a printout by purchase date.  This one is oftentimes harder for a client to produce, but the information is in the system, it’s just a matter of IT assisting with running the report. This allows you to review the age of the inventory and if the dates are reasonable.  This was helpful several years back when performing inventory in a warehouse.  There was a product that was three years old, carried at approximately $45K.  I found out the purchasing department had gotten a “great deal” on this product.  However, that great deal didn’t translate to sales and there it sat, for several years.

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 obverse 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.  Another tactic I use is to simply walk through the entire warehouse.  I examine if there is inventory that appears damaged, I have sealed boxes opened to verify the product on the label is actually in the box.  Additionally, I also look for dust and cobwebs.  Inventory with lots of dust and cobwebs has probably been there for a while and may be obsolete.

Perform surprise audits of inventory – 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 3am.

Review of manual journal entries – 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?

Install security cameras – 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.  One of my clients was able to prove theft by catching an employee stealing on camera.  What was interesting is that the employee was aware the camera was there.

Physical controls – Ensure inventory kept at a secure location and only authorized access is permitted.  Is it gated, locked and access restricted to authorized personnel?

For those who like movies and TV shows check out the following:

  • The Thomas Crown Affair (1999) – a billionaire steals a painting from an art gallery and is pursued by an insurance investigator. 
  • Ocean’s Eleven (2001) – Scheme to rob a casino that was required to have cash on hand to cover bets during a highly publicized boxing match. 
  • Locked Down (2021) – follows a couple who plan to execute a heist of a jewelry store.
  • Gone in 60 Seconds (2000) – a car thief is forced to steal 50 luxury vehicles in one night.
  • The Italian Job (2003) – entails an elaborate gold heist against a former ally.
  • Inside Man (2006) – a bank robber that steals from a lock box, and takes not cash.
  • White Collar (2009-2014 TV Series) – a con artist works as a consultant for the FBI – this was listed in my last article, but it’s one of my favorite shows of all time. It’s clean, wholesome, funny and enlightening. I recommend checking this out as its pretty much family friendly.

In closing, inventory theft is something that we all pay for in some way, shape or matter, as it results in an increase in the cost of the products we purchase or consume.  Hopefully this article provided a few tips that your company can implement and will result in reviewing your financial records in a new light.