For many businesses, such as retailers, manufacturers and contractors, strict inventory control is central to operations. If you don’t track inventory accurately, you can’t effectively produce goods, meet customer demand and realize profits.

Let’s say you’re performing a year-end inventory count and you come up short. Have you miscounted or have the items been misplaced? Or has someone stolen inventory? A professional fraud expert can help you get to the bottom of such discrepancies.

Assuming an innocent explanation

Before assuming theft, experts investigate whether missing inventory items were really stolen. Employees might have kept sloppy records or failed to follow proper procedures, resulting in “missing” inventory. For example, a company without a location assignment for each item, an effective method of tracking overflow stock, and a well-run returns system can easily misplace inventory.

If there’s no innocent explanation for inventory shrink, the expert next looks for signs that the environment is conducive to fraud. These might include:

• Poor internal controls for purchasing, receiving and cash disbursement,
• Reliance on one worker to perform multiple inventory duties, and
• Weak management oversight of the inventory function.

If the expert believes inventory could have been stolen, records will generally be combed for evidence. Anything that doesn’t follow established inventory procedures — such as large gross margin decreases — could be a red flag.

Finding fraud evidence where red flags fly

Inventory fraud may leave a paper or electronic trail, so fraud experts typically review journal entries for unusual patterns. An entry recording a physical count adjustment made during a period when no count was taken warrants investigation. An expert might then trace unusual entries to supporting documents.

Vendor lists also could show suspicious patterns, such as post office box addresses substituting for street addresses, vendors with several addresses and names closely resembling (but different from) those of established vendors. Even if they find no evidence of fake vendors, fraud experts usually look at vendor invoices and purchase orders for anomalies such as unusually large invoices or alleged purchases that don’t involve delivery of goods. They also familiarize themselves with the cost, timing and purpose of routine purchases and flag any that deviate from the norm.

Confirming physical inventory

It’s important to confirm physical inventory as well. A fraud expert sometimes recommends hiring an outside firm to perform a count and value inventory to minimize risk that the fraud perpetrator will be on the team.

Whether employees or inventory specialists perform the job, fraud experts carefully observe warehouse activity once employees realize a count is imminent. Thieves may attempt to shift inventory from another location to substitute for missing items they know will be discovered.

Automating your inventory

To help prevent inventory shrink by employees and other parties, automate your inventory control. If you don’t already use it, know that the technology is relatively affordable (even for small businesses), and that it costs much less than potential fraud losses.

(This is Blog Post #1596)