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Inventory Fraud in a Chinese Company
Inventory fraud refers to the theft of physical items in a company’s warehouse and to the misstatement of inventory records in the financial statement. Inventory is one of the main areas in accounting that is susceptible to fraud. In the following case study, S.J. Grand gives an overview of the main causes of inventory fraud in a China-based company.
Foreign investors should adopt timely fraud detection strategies to save their branch revenues.
Case details
There are two main ways in which inventory fraud can be caused. The first one is by stealing real goods (physical loss); the second one is by defrauding the financial statement.
- Physical loss: it happens when the employee steals goods from the inventory for personal use or for resale. It can mainly be detected in B2C sectors, where products are easy to hide;
- Inventory overstatement or understatement: it involves the senior management, whose purpose is to reach pre-determined financial goals or benchmarks. Financial statement manipulation is an easy way to commit fraud, as it allows to show higher numbers to impress stockholders and bank creditors (overstatement). In parallel, it can happen the opposite: the management could communicate lower profits to reduce the taxable income (understatement).
Our case study examines the first inventory fraud, which is a common practice in trading companies in the P.R.C. as the goods can be hide or replaced easily.
Our client, a leading foreign distributor of alcoholic beverages in China, hired us to carry out the stock take value. This process requires that every item in the stock is counted and valued in its cost. We used data analytics and in person inventory verifications (common tactic in China).
During the stock take value we discovered that some products had been replaced with counterfeits. Moreover, some goods were declared unfit for sale or damaged. S.J. Grand’s team then realized that those items were sold in the black market. The management system was generally flawed.
We found out that the number of “no sale” transactions was high and that the company was experiencing a shortage in cash. Of course, misstatements in the inventory caused errors in the net income and gross profits.
S.J. Grand valuated the damage at several million CNY. The company lost good business opportunities as costumers were complaining about the bad quality of some bottles of wine and liquors. Our team also identified the culprits: the Sales Manager and his team of three younger guys. As a consequence of the fraud, S.J. Grand team had to structure the inventory from scratch, rebuilding the inventory management system to protect against fraud as much as possible.
We installed a system of video surveillance inside the warehouse and we trained the new employees. We established a system of rewards when somebody reported a case of theft with supporting proofs.
WAYS TO PREVENT FRAUD ACCORDING TO THIS CASE STUDY
Inventory frauds are one of the simplest ways to steal from a company. Enterprises can take several measures to prevent fraud and catch the felon. These measures include:
- Installing a video surveillance system;
- Performing random inventory audits to test the accuracy of the perpetual accounting system;
- Establishing rewards for employees that report theft;
- Making employees’ background checks;
- Carrying out secret shopping activities;
- Controlling trash.
Further precautionary techniques can prevent physical inventory and financial statements frauds:
- Shipping invoices should be physically attached to either purchase or sales invoices;
- Shipping and receiving duties should be separated from those employees who have the responsibility to issue invoices (tasks division);
- Examination of write-offs for obsolescent or spoiled goods should be done frequently.
- Analysis of financial statements comparing ratios of different periods (current and past) and ratios of the industry.
“A business without risks does not exists” comments our Managing Director, Stephane J. Grand. Nevertheless, a valid piece of advice for China is to be present and invest money in control. Fraud is a real threat, but multiple strategies can toss culprits out, discouraging them from committing illegal actions.
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