COMPANIES LOSE AN AVERAGE 6 PERCENT of their total revenue to fraud by their own employees--at a cost of $600 billion every year, far more than armed robbery. And unlike armed robbery, fraud is an inside job. How can you tell if fraud is going on in your company? More importantly, how can you prevent it in the first place? Here's a look at who commits fraud, how they do it, and how to spot what they've done.

Who does the stealing?

The typical perpetrator isn't a high-school dropout; it's a college-educated white male. And while there may be more rank-and-file employees involved in fraud, losses from managerial fraud are four times higher, and those from executive fraud are 16 times higher. Employees who commit fraud rationalize the crime in several ways: It's only fair. Everybody else does it. No one will know. I'll repay it eventually.

A company may inadvertently invite fraud--through poor screening of new hires, by failing to document disciplinary actions, by inconsistent personnel policies, and by neglecting to inform employees about internal controls. And the internal controls may not be much help anyway, if they're insufficient or easily neutralized--or sometimes if they're too consistent.

Rank-and-file employees--Common inventory fraud by employees includes direct theft, good inventory scrapped and sold, sales refund schemes, and unauthorized outbound shipments.

Some production processes involve complex accounting systems, numerous employees and large volumes of product. All this makes inventory fraud particularly difficult to detect and prevent. The most attractive inventory is small and portable, very valuable, or easily marketable.

Management -- A dishonest manager may try to misrepresent operational performance and earnings by inflating inventory, because for many firms the largest expense is cost of goods sold. The fraud may involve manipulating physical quantities or falsifying their values. There may be empty boxes in a warehouse, bricks packaged as computer parts, tags altered after a count, multiple counts of the same items, rigged barter transactions and bulk sales, or any of a thousand other things.

Sometimes the object isn't to inflate inventory, but to understate it. Minimizing stock-on-hand can be attractive to business owners who want to evade taxes, or are facing penalties from business or personal legal proceedings and want to hide assets.

How the fraud is done

Some fraud schemes arise quickly when a company's lax oversight makes for easy picking. Others may involve elaborate planning by trusted employees who know the details of the company's operations or are close to key partners.

The first step in a fraud scheme is often a test designed to see how the company responds. There may be an "accident" or anonymous small-scale theft. If that goes well, the plan develops further. Here are some common targets:

* Accounts Payable can deliver kited or forged checks, kickbacks, rigged bids, transfers to fictitious payees and even paychecks to ghost employees.

* Accounts Receivable can permit lapping--the ongoing replacement of stolen receipts with subsequent thefts.

* Expense accounts can hide inflated or invented costs for travel, entertainment, supplies or seminars.

* Inventory is vulnerable to theft, diversion, overstatement, understatement, quality substitution, false weights and measures, short shipments or false valuation.

What happens after the crime depends on how likely it is to be detected. If detection is unlikely, the perpetrators may lie low. If not, they resign before the crime is discovered.

Ways to detect inventory fraud

The basic tools for uncovering inventory fraud are tests for quantities, compilation and valuation.

Testing by physical count -- Cycle counts or continuous updates are customary ways to account for inventory, but for a fraud investigation you'll probably need a full physical count. It's a good idea to hire an outside inventory services firm for this. It will conduct its count efficiently, with a minimum of notice and using its own count team.

It's vital to guard the integrity of the count. It should be done outside the view of employees, and with strict controls over count sheets and/or tags, whether used, unused or voided. The counters should examine inventory contents, with tests for purity and grade if appropriate.

The counters should also check records to make sure that goods received and shipped near the date of the inventory were properly included or excluded.

Testing inventory compilation -- Earlier we mentioned falsification of counting and pricing of inventory. This is especially likely when counts of the same items at various locations are aggregated into one list. Investigators should inspect not just the final list, but every iteration that preceded it.

Testing inventory valuation -- It's vital to confirm that all the invoices from vendors support the stated value of inventory on hand. If a company uses the dollar-value LIFO (last-in, first-out) method, there may be manipulation of LIFO pools to inflate ending inventory.

In an average-cost system, slow-moving items deserve particular scrutiny, which may require purchase and sales documents from several years. Investigators should demand an explanation for any improperly valued items. And they must not be fooled by doubletalk, evasive responses or complex pricing formulas.

Inventory fraud presents costly and complex challenges--challenges a distribution company, whose core business isn't policing or investigating, may have difficulty meeting. Often the best course is to contact consultants and specialists trained in company-wide risk assessment, computerized models for detecting suspicious patterns, physical inventory counts and financial statement analysis.

RELATED ARTICLE: FIVE WARNING SIGNS OF INVENTORY FRAUD

Some early warning signs of inventory fraud include:

1. Unexpected shortages or fluctuations in inventory accounts

2. Large adjustments to counts after a physical inventory

3. Significant increases in cost of goods sold

4. Significant decreases in gross margins

5. Unusual or late journal entries

You'll need to do an objective analysis to spot these symptoms. One useful method is to calculate three ratios in detail regularly and in different months or quarters: age of inventory, gross profit margins and inventory turnover. But don't instantly assume fraud if something shows up. It may indicate just faulty record keeping, which is fairly common in this area.

By James E. Merklin, Contributing Editor

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