6 Ways to Prevent Inventory Fraud in Your Business

by Darin Styles, CPA, CFE

The mention of “corporate fraud” often conjures up images of money—money-laundering schemes, embezzled checks, and fraudulent charges on a company account. But workplace fraud can and often does involve noncash assets. In fact, noncash fraud schemes account for 19% of fraud cases uncovered in small businesses with more than 100 employees, according to the Association of Certified Fraud Examiners’ 2020 Report to the Nations on Occupational Fraud and Abuse.

Inventory fraud is one such noncash scheme. It could be as minor as an employee stealing a bottle of soda off the line or as complex as a production manager selling company-owned raw materials to a third party. Unfortunately, the current COVID-19 situation could create new opportunities for inventory fraud. For instance, having fewer employees on-site is likely to reduce the level of oversight, which could make it easier for an employee to commit fraud. Also, remote work arrangements could disrupt processes and, ultimately, internal controls.

Needless to say, inventory fraud could be devastating to your business, and now is not the time to let down your guard. Here are six ways to prevent it.

1. Practice proper segregation of duties.

Segregation of duties is one of the most basic fraud-prevention measures you can take. Simply put, “segregation of duties” means you don’t allow one person to be involved in two processes that have a conflict of interest. For example, never put the same employee, no matter how trusted, in charge of both production and shipping.

If you have employees working from home, however, your segregation of duties practices could become more complicated. Consider evaluating who’s working from home as well as their responsibilities, so you can ensure duties are properly segregated.

A dispersed staff could also impact how assets, such as sensitive financial documents, travel through your organization. Some assets previously handed off in person must now be transferred electronically. What’s more, these assets may no longer have appropriate chronological documentation or a paper trail. Paying attention to an asset’s “chain of custody”—i.e., the people who have had ownership of an asset—is critical to prevent it from falling into the wrong hands.

2. Implement a formal management reporting process.

A detailed management reporting package can serve as your canary in the coal mine. Regularly reviewing these with your key managers and department heads can help you spot fraud in its earliest stages.

Ideally, your management reports should clearly show your company’s key performance indicators (KPIs), which are numeric measures of performance that correlate with your key business objectives. This level of detail allows you to more easily pick out anomalies and variances. It also gives you the opportunity to ask questions if needed. The more light you can shed on the nuances of your operations, the better.

3. Incorporate the element of surprise.

Incorporating the element of surprise into your internal controls creates a threat of detection—an excellent fraud deterrent. For instance, consider conducting surprise stock counts or doing an unannounced shipping audit. If employees know you could show up at any minute, they will be less likely to engage in fraudulent behavior. What’s more, if fraud were to be in progress, your surprise action could potentially detect it.

4. Automate your processes.

Eliminating opportunities for product to be manually adjusted can reduce opportunities for fraud. Unfortunately, automating a process is easier said than done. If you’re unable to purchase and/or implement an automated system, consider looking into the capabilities of your current system(s). Could it be doing more for you, or have you outgrown it?

5. Conduct a production yield analysis.

As I’ve said before, data analytics is a powerful tool for detecting and preventing fraud. Analyzing your production yield—that is, your actual output versus a standard output calculated from standard inputs of materials and labor—can help you see if a discrepancy exists between the two. If it does, and you don’t have an explanation for the variance, it may be worth further investigation.

6. Pay special attention to bill and hold arrangements.

These types of arrangements, in which a company recognizes revenue prior to the delivery of purchased goods, can be easily abused by fraudsters. If you use bill and hold transactions, it’s important to be diligent about the accounting involved, especially given the current economic climate. It’s likely you could end up holding onto inventory items longer than expected.

Don’t let inventory fraud impact your business.

One final thought: The 2020 ACFE report I referenced above found that noncash fraud schemes last, on average, for 13 months. This is plenty of time for a fraudster to cause lasting damage—and a good reason to start implementing these six fraud prevention practices as soon as possible. The sooner you can detect fraud, the better. If you’d like to explore your options for preventing and detecting inventory fraud in your business, contact us today.