Inventory Frauds
What is occupational fraud?
Occupational fraud, or employee fraud, is fraud committed by an employee on an employer. They are more common and cause more financial loss to businesses than other third party frauds. As employees will continue to work at the business, they will generally try to hide these frauds permanently.
What is inventory fraud?
Inventory fraud is the misappropriation of inventory items by an employee from an employer. The three major types of inventory fraud each hide the theft by attacking the business system in a different manner
(a) Inventory Record schemes - attack the perpetual inventory records;
(b) False Sales schemes - attack the sales documents that affect the perpetual records; and
(c) Purchasing schemes - attack the purchase documents that affect the perpetual records.
What is the difference between these frauds?
How they differ is:
(1) whether the target is inventory on hand or inventory being purchased but yet to be received; and
(2) what records are falsified to hide the loss.
Who commits inventory fraud?
Anyone with physical access to, or who controls the purchase of, inventory has the opportunity to steal it. Employees in different areas of the business may have to commit different types of fraud depending on their access to the business system. A purchasing officer will usually not be able to adjust inventory records, and a salesperson may only have access to sales records, so their frauds will be different.
INVENTORY RECORD SCHEMES
What is inventory record fraud?
This is inventory fraud that is hidden by the manipulation of the inventory records themselves, not the sales or purchases documents that lead to entries in these records. It is usually committed by an employee with regular access to these records - whether during business hours, after hours, or at other times when there are not sufficient controls in place.
The three common inventory record frauds are:
(1) False write-offs;
(2) Perpetual record manipulation; and
(3) False stock takes.
In all cases, the stolen inventory item must be removed from the site.
False Write-Off Frauds
False write-off frauds is done by putting an entry into the inventory system that results in the stolen item being recorded as damaged, discarded or returned.
False write off schemes can be done by any one with access to the inventory records, or with the authority to write off inventory as damaged or scrap, or whose supervisor does not adequately check these requests. The fraud can be committed by issuing and authorizing a false source document that will be recorded in the perpetual records reducing the number of items held. The item is stolen, but it is not missed when stock takes are performed, as it is no longer in the records.
Perpetual Record Manipulation
Perpetual record manipulation falsifies the inventory records directly (without a source document), removing the item from the stock list.
The employee simply adjusts the stock records to show one less item. This can be done by changing the ending balance in the inventory ledger or inserting a false credit (a sale, write off etc.). It does not rely on a source document being prepared and authorized. When the stock-take is performed, the amount in the records should match the physical count. The degree of difficulty will relate to the sophistication of the record keeping system and the controls that are in place over these records.
False Stock Takes
False stock takes do not adjust the records, they falsify the stock count to equal the perpetual inventory records. This scheme does not permanently hide the theft, and must be repeated at the next stock take. Stock takes are meant to uncover differences between the perpetual records and physical counts. Falsifying the stock take hides that difference. This is sometimes known as "pushing the balances".
Deterrence and Detection
One common factor in these frauds is the theft of the item and its removal from the premises. Physical security over the items should reduce the opportunity to actually steal the item. Independent verification of records and separation of duties in the recording process also reduces the opportunity to commit these frauds.
Stock takes should be performed by people independent to the stock area, or independent to the business. Write offs in the records should be verified by a supervisor and the item properly handled (sold as scrap, returned to suppliers etc.). Rarely is a written off item worth nothing.
Entries in the perpetual records should be checked against to a separate purchase, sale or other record and checks should be performed on those documents from time to time. The belief that the fraud may be uncovered will stop a lot of people from committing the act in the first place. This is called the "Perception of Detection".
FALSE SALE SCHEMES
What is false sales fraud?
This is inventory fraud that is hidden by recording a fictitious sale of the stolen item. This can be done by recording a credit sale of the item where that debt is never collected, or not recording the sales part of the transaction in the sales register, only recording the cost of sales part in the inventory records.
What is the difference from inventory record frauds?
This fraud is similar, but the entry in the inventory records will come from a valid looking source document - usually from another area of the business. False sale frauds record the stolen item as legitimately sold. The fraud is usually committed by someone outside the inventory area.
How do false sale frauds work?
The aim is to have the stolen item recorded as sold by falsely producing a sales document. The false sale is recorded in the inventory records, reducing the stock level. Then either:
(1) the sale is not recorded in the sales records, which may be kept independently from the inventory records. As there is no sale and no amount to collect or bank, the sale is never missed.(2) a credit sale may be recorded (probably under a false name) and the amount eventually written off as uncollectable. By the time that the sale is written off, the trail will be cold.
(3) In manufacturing businesses, the stolen item can be allocated to work in progress as opposed to a sale. This is effectively an internal sale of the item.
Deterrence and Detection
Internal controls over the recording of sales limit the opportunity to commit the fraud. But it may not be practical to have a lot of controls if there is a high turnover of inventory items. The use of computerized point of sale registers provides some controls with the automatic updating of inventory records along with the recording of the sale. But computerized systems will not stop people stealing inventory and not recording the sale.
Where the individual items are of large value (cars or boats), it is easier to manually verify each sale to a stock item and ensure proper recording. Manufacturing businesses have their own special needs as the stock is not recorded as sold, but allocated to a job or process. The controls on these allocations are usually less stringent than for sales of stock, as the use of the stock is internal.
The best prevention technique is ensuring that the recording system will provide verification of sales at the time of the release of stock.
PURCHASING SCHEMES
What is purchasing fraud?
Purchasing fraud is the theft of inventory as it is being purchased, and before it is received and recorded in the inventory records. This is the opposite of a false sales fraud where the item is already in the system. The purchase is recorded and the business receives the invoice for the item, but the receipt of the item is not recorded in the inventory records so the item itself is not missed.
There are two sets of transactions in any purchase. The first is the monetary side. This records a purchase and a debt to be paid. The other side records the receipt of the item and updates the inventory records. This second part is bypassed in this fraud.
How does purchasing fraud work?
Authority to order inventory is not necessary, but the fraud is more difficult without it. The item is ordered and delivered to the location specified by the fraudster, or he may collect it directly. The benefit of the fraud is that the item does not have to be physically removed from the site. The purchase is recorded in the financial records, but the order is not processed in the inventory records.
As the order paperwork is not forwarded to the inventory area, the item is never expected to be received. According to the inventory records, the business does not have the item, so it is not missed during stock takes. The invoice is processed under the belief that the items on the invoice have all been received. The business will then pay for the item.
Deterrence and Detection
The fraud can be committed when the receipt and authorization of invoices for payment are not well controlled. Recording the item in physical inventory should be linked to the authorization of the invoice for payment. If these two steps are connected and properly checked, the chances of conducting this fraud will be reduced.
If the inventory is immediately recorded when delivered and referred to the invoices, missing items should be noticed. Payment of the invoice should only be authorized after the item has been recorded as received in the inventory records. This will limit the ability of conducting the fraud to a few people.
FOR EXAMPLE
Example One
ABC was a small panel beater. The business did not keep adequate records or costing on each of the jobs. A number of employees started using stock items on their own cars and charging the items to different jobs. Due to the inadequacy of the records, the owner could not determine what items were used on each job and the business had to bear the costs of the items as they were not charged to any actual job.
Example Two
Mr P is the purchasing officer at ABC. ABC deals in DVD players. Mr P orders 1000 DVD players from a supplier. When they are collected, he authorizes the invoice for payment by the credit department for 1000 players. He records that 999 are received into stock and takes one home. A stock take will not find a discrepancy as the physical stock count matches the records.
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.
Back to Fact Sheets
Last Updated: 10.4.2008