By Craig L. Greene, CPA/CFF, CFE, MCJ

In this month's article, part of a series written on employee frauds, I examine typical inventory fraud schemes. For most businesses, inventory items are the reason that they exist. Both raw materials and completed goods can be stolen through different means. Lower level employees of an organization usually perpetrate thefts.

The most common scheme is appropriating inventory for personal use, more commonly known as theft. Theft can occur in many and varied forms. A common scheme involves collusion between delivery and receiving personnel. The receiving clerk will sign for more items than were actually received and the difference will be sold to other parties and the monies will be split between the individuals. A dock worker and route driver were able to steal $300,000 worth of inventory over six-months by not completing the load sheets correctly or accurately. The goods were then transported to an independent distributor, who then sold the goods.

Another form of theft is the ordering of excess inventory items and then converting the excess to personal use. The items are often shipped directly to the person's residence or another business. A large international construction company had a remote project. The project was understaffed as to supervisory personnel, which resulted in one person ordered, received, and supervised the materials required for the project. The employee, who was with the company for 15 years, ordered excess building materials, auto parts, and other goods, which he then removed, from the job site. The other project staff members were also long time employees of the company, but apparently no one questioned the discrepancies. When the misappropriations were discovered after about six months, the 45-year-old employee was disciplined but not prosecuted. The amount of the materials taken was approximately $5,000. In another case, an employee of a motion picture company misappropriated $470,000 over a two-year period. Operating procedures allowed the employee to arrange for outside script copying services, receive script copies, and approve payments. The employee set up a fictitious corporation, submitted invoices for services never rendered, and charged the production of films shot at the studio. The scheme was discovered when invoices were charged to a picture that was never produced.

Another theft scheme involves the use of scrap proceeds. Since scrap sales are usually not controlled and inventories are not well kept, individuals can underreport the amounts received through the sales. Another problem is designating good inventory items as scrap and selling them to a party whom will then resell the item and divide the gain. Several employees in the engine repair department of a major defense contractor colluded with the inspectors to declare the engines as scrap when they were not. The engines were then stripped of their gold plating and then sold in various parts of the world. It was reported that some of the engines had been repaired, but these engines had not been repaired at all. The gold plating had been removed from the functioning engines and replaced with silver plating. The silver plating was then painted gold to appear to be in accordance with the engine's specifications. The amount of the fraud was in excess of $2 million dollars, and several lives were lost as a result of accidents.

Since inventory accounts are generally not reconciled until the end of each year, it is usually a simple matter to charge embezzlements as inventory purchases. Embezzlements are often charged to inventory or another expense account since these accounts are closed to the retained earnings of the business and thereby obscuring or erasing the audit trail. Inventory accounts are often used because the larger balances are large enough to accumulate the entries required to conceal large losses. The athletic department public relations division of a major university received tickets from the athletic office for the purpose of reselling the tickets to donors of the university. The ticket office for the tickets it received billed the public relations division. When the public relations division sold the tickets, an employee retained the sales proceeds using donations to pay the billing from the athletic department. Further investigation revealed that the donor checks had been substituted as payments for the athletic event tickets. The total embezzlement was approximately $45,000.

Businesses can minimize the likelihood of thefts through strengthening its internal controls. There are numerous methods to detect inventory thefts so if a business finds itself a victim of a fraud, it should consult its legal counsel, accountant, and a competent fraud examiner.