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HOW TO DETECT INVENTORY FRAUD
Inventory fraud involves the theft of physical inventory items and the misstatement of inventory records on a company's financial statements. Inventory consists of raw materials, unfinished and finished goods that are generally stored in warehouses. A small business may be a victim of fraud perpetrated by one of its employees, or the business itself may engage in fraudulent activities to trick shareholders and tax agencies. Timely fraud detection and prevention can save your small business time and money.
1. Detect inventory theft, which is the removal of inventory from storage for resale or personal use. The warning signs include missing packing slips and sales receipts, employees living above their means, complaints from customers about lost goods, spikes in the number of damaged goods and sharp drops in sales, even during normally busy periods. To prevent theft, lock your storage areas, install video monitoring and alarm systems in your warehouse, run background checks on your employees and conduct random physical audits of your inventory.
2. Look for risk factors of inventory fraud. In a June 2001 "Journal of Accountancy" article, Joseph T. Wells -- founder and chairman of the Association of Certified Fraud Examiners -- wrote that these risk factors include attempts to obtain inventory-backed financing and unusually high inventory balances. A company using inventory to obtain financing might be tempted to inflate the inventory balance.
3. Find errors or misstatements in reported inventory balances. Overstating and understating the ending inventory balances can inflate and reduce profits, respectively. Overstated profits make management look good, while understated profits reduce taxable income. The signs of possible financial statement fraud include stagnant inventory balances for several consecutive accounting periods and inventory balances rising faster than sales. You can prevent some of these fraud attempts by conducting surprise audits and by separating the invoicing and shipping responsibilities.
4. Spot unusual trends in certain financial ratios involving inventory. Possible signs of fraud include inventory balances rising faster than sales and shipping costs decreasing as a percentage of inventory. Determine if the inventory turnover -- which is the ratio of the cost of goods sold to inventory -- shows sudden changes or if it's significantly different from industry trends. Check if the cost of goods sold on the company's books is different from the tax returns. For a small retailer, the cost of goods sold is equal to the difference in the beginning and ending inventory balances of an accounting period plus inventory purchases during the period.
5. Watch for attempts to create phantom inventory. Wells wrote that attempts to fool auditors may include falsified purchase orders, bogus shipping and receiving reports, inflated inventory counts and even stacking empty packing boxes to create the appearance of a warehouse filled with inventory..