In this article, we have discussed the fraud early warning signs and the various possible ways companies can prevent it by putting the right internal control system in place.
Many companies are out of business or have lost a fortune due to Inventory Fraud (‘the fraud’). This kind of fraud is peculiar to companies operating within the manufacturing, retail, or construction industry. The fraud is usually perpetrated by key employees, or the business itself may engage in fraudulent activities to trick shareholders, potential investors, and tax authorities.
Inventory, sometimes called stock, is often one of the biggest assets in a manufacturer’s financial position. It is also a difficult asset to measure and monitor. Hence, safeguarding it becomes paramount for business growth and survival.
What is Inventory Fraud?
Inventory Fraud is one amongst the non-cash fraud schemes. It entails the theft of physical stock items for personal gains and/or the manipulation of a company’s stock records to report a favourable position. The fraud is often perpetrated by employees with access to inventory items in a company, or a corporation itself through manipulation of certain account balances to misrepresent the inventory balance to deceive shareholders, potential investors, and tax authorities.
Inventory fraud could take different forms including under casting the proceeds from the sale of scraps, outright theft, bill-and-hold sales, cut-off schemes, capitalizing costs that should be expensed.
Inventory Fraud Early Warning Signs
Companies should continually watch out for inventory fraud early warning signs in their system to be in a safer region. Highlighted below are some of these signs:
- Excessive cost of sales: Most times, the inventory account is simply a commonplace where fraudsters hide their fictitious numbers through passing a serial of unexplained journal entries and then closing them out to the cost of sales. Whenever the reported cost of sales is quite higher than the budgeted in relation to revenue, management should ensure they investigate further to ensure stolen inventory is not being hidden within the cost of sales.
- High inventory days metric: This is often one amongst the fraud indicators. This metric is calculated as average inventory divided by the annual cost of sales times 365 days. Higher inventory days could indicate that a corporation is carrying non-existing inventory in its books.
- System quantity does not agree to the physical inventory: This is a strong red flag that all is not well with inventory, and it calls for further investigation of the discrepancies.
Possible Inventory Fraud Preventive Measures
Sadly, the present Covid-19 pandemic could create incentives for inventory fraud. As an example, having fewer staff on-site is probably going to scale back the extent of oversight, which could make it easier for staff to perpetrate fraud. Moreso, remote work situations could disrupt processes and, particularly, internal controls thereby increasing the risk of fraud.
Companies exposed to inventory fraud could take the subsequent fraud preventive measures to curb the danger of going bankrupt:
- By segregation of duties: Conflicting tasks or functions should be handled by different persons within the organization instead of entrusting them with one person. Within the case of a manufacturing company, the person involved within the production process should not even be involved in dispatching goods to customers.
- By performing a regular production yield analysis: A system that compares the actual output of production with the standard output based on standard inputs should be established so that differences in materials and labour costs are brought to light on the spot. This would go a long way depicting the efficiency in the production process and fraud is detected and possibly prevented much sooner before it is too late.
- By carrying out surprise inventory counts: A regular surprise inventory count could function as a superb fraud deterrent. If inventory counts are not adding up, it is advisable not to just write off any difference between the count’s result and the physical inventory to cost of sales by rather investigating the root cause and taking proper corrective actions.
- By automating the production process so that no persons within the organization can interfere with how material mix and costs are determined and their subsequent release to cost of sales. Manual processes are usually susceptible to errors and fraud.
- Installation of CCTV to increase vigilance around the entity to deter persons with intention of theft.
- Establishing a strong fraud management system that would facilitate prevention and early detection of inventory fraud and misstatements of inventory balance.
- By living in a corporate culture: A positive work environment will prevent fraud. There should be a clear organizational structure, written policies and procedures and fair employment practices. An open-door policy can also provide a great fraud prevention system as it gives employees a positive open line of communication with management. Business owners and senior management should lead by example and hold every employee accountable for their actions.
Oftentimes, during the perpetual year-end inventory counts, victim organizations write off discrepancies between the book value and the physical inventory to cost of sales without properly analyzing the root cause of the discrepancies. In fact, these organizations entrust the staff with several conflicting tasks.
In fact, some companies even go far as falsifying their information to trick tax agencies or shareholders, attempts to fool company investors by including bogus purchase orders, fabricated shipping, receiving reports, and inflated inventory counts. Also, fraudsters might even stack empty packing boxes in the company warehouse to give a false appearance of the inventory.
If the inventory fraud mechanisms are not given the proper attention by looking a way to prevent or reduce them in an organisation, it could lead to the end of such business. Every modern organization should strive to maximize its shareholders’ wealth, and ensure an appropriate system is established to manage this wealth. Organizations should ensure fraud early warning signs are regularly monitored and investigated whenever these signs are evident within the system.
Inventory fraud deterrent mechanisms should be established in prone organizations and, where necessary, perform a regular system assessment and inventory audit.
Manager, Audit & Assurance Services
Associate, Audit & Assurance Services