Inventory Record Frauds

What is Occupational Fraud?

Occupational fraud is fraud committed by an employee on an employer in the course of their employment. They are more common and cause more financial loss to businesses than frauds committed by third parties. As employees will continue to work at the business, they will generally try to hide these frauds permanently, meaning that occupational fraud can be committed over an extended period of time.

What are inventory record frauds?

These are frauds that involve the theft of inventory items when the theft is hidden by manipulating the perpetual inventory records. The other main method is hiding the theft through sale or purchase frauds, which are the subject to another paper in the series.

Major Headings

Description of Inventory Record Frauds
Hiding the loss
1. False Write-Off Schemes
2. False Stock Takes
3. Perpetual Record Schemes
4. False Receiving Documentation
For Example
Lessons to be Learned
Prevention and Detection

Description of Inventory Record Frauds

Inventory can be the target of fraud. It is usually the largest dollar value asset of retail businesses and a large portion of the asset value of manufacturing businesses. Most non-service businesses have at least some level of inventory or supplies on hand.

The theft of physical assets is common. One common target of these thefts is inventory items, as inventory items can numerous; can be of small value; may be readily accessible and removable; may not well protected; and may not be immediately missed, if missed at all.

Although this paper describes the theft of inventory, the same type of fraud may be undertaken with other physical assets used in a business. In these cases the asset register (if one is maintained) is manipulated instead of the inventory records.

How is the fraud done?

Stealing inventory items can be easy. Any lack of physical security contributes to the theft of inventory, by both employees and non-employees. If items are openly available to any employee without authorization or requisition, inventory will be susceptible to theft. But these items need to be freely available to salespeople in most retail businesses. Manufacturing businesses also need easy access to materials to work efficiently.

Leaving inventory items unsecured during and after business hours provides the opportunity for theft. After-hours access provides the opportunity for employees to not only take assets, but also the time to manipulate the business records to hide the loss without other people present. Physical security limits this opportunity. If the employees cannot physically access and remove inventory items, avenues for losses from fraud are limited.

Hiding the theft of inventory in the business records is the more difficult part of the fraud. If the theft is a one time event, the employee may not attempt to hide the theft. Depending on the type of item stolen, they may leave the loss to be noticed at the next time stock-take believing that the loss will not be able to be traced back to them. If the employee wishes to continue the thefts over a period of time, they will probably need to hide the losses. How the loss is hidden specifies which type of fraud has been committed.

Once inventory has been stolen, the loss should normally show up in the perpetual inventory records during the next stock-take. The records must be altered to hide the loss. Inventory record frauds are based on hiding the theft directly in the inventory records through one of these methods:

(i) False Write-Offs
(ii) False Stock Takes
(iii) Falsifying Perpetual Record
(iv) False Receiving Documentation

Hiding the loss

1. False Write-Offs

This fraud is done by writing off the stolen inventory item as scrap or similar in the inventory records so that they coincide with the actual physical inventory levels. A stock count will show the 'correct' number of items and the loss will not be noticed. Hiding the theft in this way requires either access to the inventory records, or the authorization the write-off. The benefit of this scheme is that the cover is permanent - once an item is written off, it is written off for good.

If the employee has the authority to write off inventory in the perpetual inventory records, the fraud is theoretically easy to commit. The inventory item is just removed and written off as scrap. If the employee does not have that authority, they still may be able to either access the records directly or falsify a write-off authorisation and have the entry made in the perpetual records, or convince the person with that authority that the item was scrapped.

The businesses may have systems for writing off scrap or reworking damaged items, or processing returns to suppliers. It may not just be assumed that missing items have been scrapped without some verification. Without enforcing these systems, anyone with the authority to write off inventory, is willing to forge that authorisation, or is able to convince that someone else to write it off, will be able to misappropriate inventory and hide it.

2. False Stock Takes

The stock-take process compares stock counts to perpetual inventory records. It matches what is there with what should be there. An alternative to falsifying perpetual records (what should be there) is falsifying the stock count (what is there). The physical count is simply adjusted during the stock-take process to match the level of stock in the perpetual records.

This is one of the simplest methods of hiding losses of stock, but only can be done if the employee performs the count or has access to the count sheets before they are compared to the perpetual records.

But adjusting stock counts is only a temporary fix. The perpetual records are not adjusted to the actual level of inventory. The next stock count will also have to be falsified, but that next stock-take may be up to 24 months after the theft occurred and the trail to the employee would then be cold. If stock takes are only an annual event, hiding the loss once may protect the employee, even though the loss may eventually be noticed.

3. Falsifying Perpetual Record

Instead of falsifying documents that cause entries to be put into perpetual records, the perpetual records may be falsified directly. The difference is the point of attack. Entries are simply made in the records that adjust the balance of inventory for the amount stolen. A stock count will then agree to the perpetual records.

This fraud requires access to the perpetual inventory records or the inventory database. That access can be gained properly or covertly and, depending on the type of system in place, the entry may not appear on any audit trail.

The false entry can look legitimate: a return to a supplier, a write off of scrap, a sale or other usage of the item - or existing entries may simply be changed as required. Business owners may never examine these records or compare them to sales or purchase records. So a false sale may never be verified against the sales records to discover whether the sale actually occurred.

4. False Receiving Documentation

Receiving records may be generated when stock items or other pieces of equipment are delivered by suppliers. They are used to add the new items in the perpetual records and verify the receipt for payment of the invoice. Employees may falsify the amount of stock received on the documents used to adjust stock records. The part of the document used to verify the dollar amounts are not amended so the supplier is paid the correct amount.

The inventory item does not need to be stolen at that time. The documents can be falsified to hide an earlier or a later theft. As the items are never recorded in the perpetual system, their theft will not cause them to be missed during a stock take. It will simply align the actual stock levels with the records.

For Example

A regional airline company flew aircraft that were not common and were reasonably old. Only two other airlines flew the same aircraft. The company maintained a store of spare parts that were no longer being manufactured. One of the other airlines had limited parts and none of the smaller parts.

The airline did not want to sell any of their stock of parts. An employee from the other airline contacted the stores manager and offered to purchase some small parts at greatly inflated prices. The stores manager stole the items, sold them to the competitor and kept the proceeds of the sale.

The company conducted a stock-take every year at 30 June. The store men undertook that stock-take and the stock-take sheets were checked by the stores manager and compared to the perpetual records. That manager (1) falsified the stock count and entered the false balances into the records to ensure that they balanced with the perpetual records; and (2) falsified the perpetual inventory records for some items directly reducing the balance for the losses.

The scheme was uncovered when liquidators were appointed to the company and an independent stock-take was undertaken and compared to the perpetual records system. The perpetual system was in the form of hand written cards. Some of these cards contained entries that could not be matched back to parts requests from the airline.

The stores manager was in charge of maintaining the records and detecting whether any of the parts may have been missing. As the records always balanced and the directors had great faith and trust in the employee they never questioned his reports.

Lessons to be Learned

1. Stock is not safe from theft, from either employees or other parties.

2. There are numerous ways for employees to hide losses, including falsifying the inventory records, or producing false documentation that will lead to improper entries into the inventory system. These frauds attack the inventory records directly.

3. Physical security protects assets. If thieves cannot get to the assets, the chance of them stealing them is reduced.

4. Physical security of inventory can be overcome if the theft of the item occurs when the item is purchased. These frauds attack inventory that has not yet been recorded in the inventory system.

5. The recording system in place to protect inventory may be manipulated and proper controls need to be implemented.

6. Falsifying inventory records or stock-takes is difficult to detect without investigation.

Prevention and Detection

Some things to look for

(i) Suspicious entries in the perpetual records, particularly ones that do not fully explain the reduction in inventory. Requiring two people sign off on all such entries adds another person to the process that may prevent the theft.
(ii) An analysis of Cost of Goods Sold (COGS) to Sales (COGS being x% of Sales) may highlight an increase in the COGS sold percentage compared to sales, and may indicate the theft of stock. Inventory turnover rates should also be compared from time to time.

(iii) Shipments of stock that do not correlate to a sales invoice should raise questions. This may indicate a shipment of stolen stock to an employee that has been done without booking a sale.

(iv) Hand written alterations to documentation that do not have sufficient independent authorization.

Some basic controls

(i) Physical Security should include proper documentation to gain access to relevant inventory. Limiting access to the stock room, particularly after hours.
(ii) Independent authorization of write-offs or scrapping of inventory items. This causes an extra set of eyes to be cast over the documentation.

(iii) Documents from the supplier should be referenced to the invoice and documentation produced to add items into the perpetual system.

(iv) Separating duties in the affected areas (ordering, receiving and recording) should add a layer of control.

(v) Proper and verified stock-takes as they may be the only way that you will ever determine that stock is missing. Perpetual records are only an active control if they are compared against physical stock-takes on a regular basis and discrepancies are investigated.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Acknowledgment
The material in this Fact Sheet was sourced from various publications including those listed in the Reading List on the Fraud Awareness page on this website.

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Last Updated: 28.6.2010