A company’s inventory is often one of the largest assets on its balance sheet. Unfortunately, inventory doesn’t always receive the careful monitoring it deserves — often at the expense of a company’s bottom line.

First Bank takes a closer look at physical inventory theft and inventory accounting fraud, and the steps business owners can take to protect their companies.

Physical Inventory Theft

Whether a business deals with raw materials, parts, supplies, or finished goods, it’s common to find small discrepancies between inventory on hand and information in the system. These discrepancies may stem from everyday factors such as damage, clerical errors, or delayed data entry, but they may also result from employee inventory fraud. For many companies, an inventory shortage exceeding two percent is cause for concern.

Know Your Risk

The risk for inventory fraud varies by industry, type of inventory, company size, and other factors. Retailers, manufacturers, and contractors that stock parts and materials often face the highest risk. Theft is especially common among companies with high-value inventory such as electronics, jewelry, brand-name merchandise, or items that can be easily resold. If a company’s inventory recording process is especially complex, that complexity may create an opportunity for a dishonest employee to cover up theft or bury another kind of accounting fraud.

Prevent Discrepancies

Habitual or systematic inventory theft can go unnoticed for many months, and the discovery of theft is sometimes only by chance or because of a glaring accounting disparity. Clearly defined protocols can help detect theft earlier or prevent it altogether, and can also help reduce losses due to carelessness. Training employees on the proper way to stock, transport, price, and record inventory — and ensuring the handling of damaged, defective, or lost items is consistent — are important first steps. Conducting spot checks and monthly inventory counts can help catch and correct errors before they cause major problems.

Get Outside Help

Hiring an outside team to perform an inventory count regularly, such as once a month or once per quarter, can help maintain a clear picture of inventory and improve reporting. While third-party counts add a recurring cost, the resulting improvements to the inventory process and reduced losses can more than make up for the expense.

Set Up Controls

Background checks and references can help identify trustworthy employees, but safeguards should still be in place to deter and catch fraud. Physical controls like video surveillance and secured access points are often crucial. Ensuring employees carefully record warehouse activity and inventory movement also maintains accountability. Because manipulating an inventory system can happen in the absence of physical theft, inventory accounting controls should be just as rigorous as those for cash management.

Fraudulent Inventory Accounting

Protecting a company’s inventory involves more than guarding against physical theft. Monitoring and implementing controls for inventory record-keeping is equally critical for retailers, manufacturers, and other inventory-based businesses.

Why It Happens

Fraudulent inventory accounting commonly hides inventory theft, but concealing a discrepancy isn’t the only motive. Dishonest management or accounting staff may manipulate inventory records to disguise or fund another scheme, such as reporting fictitious sales, skimming funds, committing tax fraud, or overstating earnings to deceive lenders or stakeholders.

How It Happens

The way a dishonest employee commits inventory fraud depends on the scheme being carried out and the individual’s access to the inventory system. Common methods include falsifying inventory counts or inflating values, failing to report new inventory, completing phony write-offs, failing to write off inventory when needed, and changing existing entries.

Investigating possible fraud in an inventory system isn’t straightforward. A midsize company may see thousands of entries in its perpetual inventory system each year, and these transactions sometimes include subjective estimates that make fraud harder to detect than in other types of accounting. When numerous employees are involved in the reporting process — whether directly or indirectly — it can be difficult to pinpoint the source of suspicious activity.

Strengthening Controls

Middle-market executives can follow these steps to boost transparency, accountability, and accuracy in inventory management: require secondary authorization for entries with insufficient information; use a third-party service for periodic inventory counts; maintain a strict authorization policy for write-offs and other inventory updates; create a clearer separation of duties to increase accountability; and regularly match cost of goods sold (COGS) to sales data, shipments to sales invoices, and supplier deliveries to inventory counts.

Investigating Possible Fraud

Routine changes — such as overhead allocations, inventory value adjustments, and write-offs of lost, damaged, or obsolete inventory — make it hard to distinguish ordinary fluctuations from deliberate manipulation. Because investigating inventory fraud is a complex process, businesses should consider hiring a forensic accountant to review and verify inventory documentation and collect the evidence needed to address the issue.

First Bank is committed to helping local businesses stay protected and financially strong. Find more resources on fraud prevention and business banking online or connect with a First Bank business banker at a branch near you.