Below are some recommended procedures to put in place to prevent fraud, but please note this is not an exhaustive list.
Physical controls are the first prevention tool for theft. Ensure inventory is kept at a secure location and only authorized access is permitted. Is it gated, locked and access restricted to authorized personnel? To illustrate, warehouses should have a limited number of doors with 24-hour surveillance inside and outside of the facilities, including dumpsters, trucks, foliage, and parking lots. Security cameras have the ability to see what is going in and out of the warehouse when you can’t be there. Just knowing they are there can be an effective deterrent for employees.
Ensure there are adequate segregation of duties between purchase authorizations, custody of the inventory, and recording the related accounting activities. For example, the employee in charge of production should not be in charge of shipping. Who can input purchase orders? Who authorizes inventory purchases? Who can edit inventory records?
Accounting information systems – Invest and fully utilize perpetual inventory systems to maintain inventory quantities and costs. Many small business do not maintain inventory accurately between reporting periods and rely on annual detective controls to true-up balances.
Perform analytical review procedures to compare what is recorded to prior years’ and current year’s actual activity. Specifically, review the amount recorded for inventory to the amount of cost of goods sold. Compare increases in inventory to increases in sales. If sales are declining, inventory should be fluctuating accordingly. How much inventory capacity does your company have compared to what your books reflect is on hand? Analyze the inventory recorded to the required square footage needed to store it. Compute inventory turnover and compare to prior periods. Analytical procedures are some of our favorite auditing tools as they are quick to perform but can speak volumes.
As an example of analyzing reasonableness, there was an instance at a restaurant in Tennessee in the early 2000’s. The restaurant was “hopping” during the day. It was full of customers, and business seemed great. The inventory being recorded as used was also in line with the restaurant’s capacity and the actual observation of the customers dining. However, after a few weeks it was noted the sales seemed low. The customers were there and the inventory was declining accordingly, but the sales recorded did not correlate. After investigating it was brought to light that the manager on duty had asked the servers to bring him the tickets for the customers, and he would process their payments. Instead, of processing the payments, he was voiding the tickets and pocketing the cash.
Analyze the valuation of inventory – Review the inventory listing to determine if the quantity on hand and the unit price for each inventory item look reasonable. Scan the listing for anomalies. Make periodic comparisons to invoices for the inventory purchase to determine if the cost recorded is reasonable. Compare the cost of the inventory to prior periods or for the past three years. Has an allowance been made for scrap, obsolete, unsalable, or slow-moving items? Is the allowance reasonable based on what is on hand, and as a percentage of sales? If you have multiple locations, obtain a printout of inventory housed at each location and analyze to determine if it is reasonable.
Perform and observe physical inventory counts – Inventory counts can be conducted via cycle counts, perpetual counts or a complete “wall to wall” count on a periodic or annual basis. Compare the results of the physical count to what is recorded in the general ledger. Oftentimes, the external auditors can be utilized to observe the physical inventory counts and to perform test counts.
Regarding the inventory counts, be sure to perform forward and backwards test counts. This entails selecting inventory items on hand and locating where they are recorded on the inventory listing. Then select items on the inventory listing and find them in the warehouse, store, etc.
Performing surprise inventory counts, even if performed on just a few select items, can be effective. This should be performed at nonstandard inventory times, such as the middle of the month, weekends, early in the morning or at 3 a.m.
Review manual journal entries booked to the inventory general ledger account. Analyze the write-offs and determine how they impact the Profit and Loss statement. Are the journal entries supported with appropriate documentation and approvals? Take a “high level” view to determine if the entry makes sense.
Unearthing financial misstatements involving inventory overstatements is less straightforward than catching people who directly steal physical assets. A forensic accountant can help you by benchmarking financial statement trends, verifying source documents and building a case that will help you prosecute fraudsters in your midst.
Inventory fraud is a pressing concern for manufacturers due to the complexity of inventory accounting and the potential for employee misconduct. To safeguard your manufacturing business, implement robust internal controls, enhance security measures, and conduct regular audits. Learn more about our specialized services for the manufacturing industry to protect your assets and secure your financial future.