What is Occupational Fraud?
Occupational fraud is fraud committed by an employee on an employer in the course of their employment. They are more common and cause more financial loss to businesses than frauds committed by third parties. As employees will continue to work at the business, they will generally try to hide these frauds permanently, meaning that occupational fraud can be committed over an extended period of time.
What are sales and purchases frauds?
These are frauds that involve the theft of inventory items, where the theft is hidden by manipulating the records generated in the sales or purchases processes, causing altered information to be recorded in the business’s books. The other method of hiding the theft is by falsifying the inventory records. This is the subject to another paper in the series.
Major Headings
Description of Sales and Purchases Fraud
Hiding the Loss1. False Sales
2. False Purchases
3. False Allocation SchemesFor Example
Lessons to be Learned
Prevention & Detection
Description of Sales and Purchases Fraud
Inventory can be the target of fraud. It is usually the largest dollar value asset of retail businesses and a large portion of the asset value of manufacturing businesses. Most non-service businesses have at least some level of inventory or supplies on hand.
The theft of physical assets is common. One common target of these thefts is inventory items, as inventory items can numerous; can be of small value; may be readily accessible and removable; may not well protected; and may not be immediately missed, if missed at all.
Although this paper describes the theft of inventory, the same type of fraud may be undertaken with other physical assets used in a business. In these cases the same type of purchase order documents are manipulated.
How is the fraud done?
Stealing inventory items can be easy. Any lack of physical security contributes to the theft of inventory, by both employees and non-employees. If items are openly available to any employee without authorization or requisition, inventory will be susceptible to theft. But these items need to be freely available to salespeople in most retail businesses. Manufacturing businesses also need easy access to materials to work efficiently.
Leaving inventory items unsecured during and after business hours provides the opportunity for theft. After-hours access provides the opportunity for employees to not only take assets, but also the time to manipulate the business records to hide the loss without other people present. Physical security limits this opportunity. If the employees cannot physically access and remove inventory items, avenues for losses from fraud are limited.
Hiding the theft of inventory in the business records is the more difficult part of the fraud. If the theft is a one time event, the employee may not attempt to hide the theft. Depending on the type of item stolen, they may leave the loss to be noticed at the next time stock-take believing that the loss will not be able to be traced back to them. If the employee wishes to continue the thefts over a period of time, they will probably need to hide the losses. How the loss is hidden specifies which type of fraud has been committed.
Once inventory has been stolen, the loss should show up in the perpetual inventory records during the next stock-take. The records must be altered to hide the loss. Sales and purchases frauds rely on the theft of the items being hidden by the falsification of sales and purchases records through one of these methods:
1. A false sale of existing inventory,
2. A falsifying records of a purchase of new inventory,
Hiding the Loss
Sales and purchases frauds involve hiding the theft of inventory items by manipulating the document that record sales or purchases of inventory, and in turn cause entries into the business’s records. The difference with these frauds and inventory records frauds is that the inventory records are not attacked directly, the attack is on the records produced in the sales or purchasing process.
There are two parts in any sale or purchase:
(1) the financial side that records the dollar value of the sale or the purchase and the collection or payment as appropriate; and
(2) the stock level side that records the increase or reduction of inventory.
These frauds manipulate the records on one side that these transactions. The ability or ease that these frauds can be committed will depend on the business system in place and the employee’s ability to gain access to that system.
They are usually either:
- A false sale of existing inventory; or
- A false purchase of new inventory
1. False Sales
The two sides of a sales transaction record the money coming in and the inventory going out. In false sale fraud – as there is no sale to record – only the inventory going out is recorded. As the levels of inventory are reduced to reflect the stolen item being sold, it can simply be taken without being missed in a stock-take. As the dollar side of the sale has not been recorded, no money is expected to be collected.
This fraud is done by producing the necessary documents to have the stock item released (if necessary) and the stock level reduced in the perpetual records. Businesses with higher value inventory items and some physical security will probably have a requisition system for obtaining items for sale. The employee will need to falsify the requisition documents to get physical access to items. That request should create the required entry in the perpetual records.
The inventory records are updated from the false source documents as if there had been a legitimate sale. Now the inventory records will match the physical level of inventory. However, as there is no sale recorded, money is not expected to be collected and will not be missed.
False allocation schemes are an adaptation of the sales frauds based on a manufacturing process. The target of the fraud can be inventory on hand, material or parts on hand, or items being purchased. The fraud is based on the false allocation of inventory to work in progress in a manufacturing process (a nominal sale). The inventory is recorded as allocated to a particular job. This fraud relies on an explanation for the use of material inventory. The rest of the scheme is the same.
2. False Purchases
False purchase schemes are based on the theft of inventory purchased before it is recorded in the perpetual system. In theory this is the opposite of the false sales fraud where the inventory records were manipulated and the dollar side avoided. False purchases need to manipulate the dollar side (so the supplier gets paid) and avoid the perpetual inventory records.
The employee may order special items to be stolen, or may steal items from a normal delivery. The employee can steal the items at the point of receipt, or if they have a special order of items, they can have them delivered to another location. This is easy if the employee can authorise purchases or can authorise requisitions for purchases. This fraud also is easier where stock is ordered for specific jobs and there is no detailed perpetual inventory system or store of inventory.
The main part of the fraud is to record the financial side of the purchase so the supplier gets paid, but not record the receipt of the items in the perpetual records. The ‘paperwork’ must be separated into the two parts of the transaction. According to the business’s inventory records, the items was never received, so they cannot be missed. It can be removed from site or collected from the outside physical site.
The scheme is completed when the invoice from the supplier for the items is paid. If the invoice is from a known supplier and for items that are usually purchased, it is likely to be paid without inquiry. The documentation from the supplier is valid. But the supplier must be paid or they will raise the invoice with the business and the fraud may be discovered.
For Example
This case involved a panel beating company. The employees had the authorization to order or use the parts required for their current jobs, without reference to management. The business owners did not check the purchases for authorizations or allocation on current jobs, or keep proper records on the job and the required parts.
The employees ordered parts for their personal vehicles and had the invoices delivered to the office for payment. The employees also ordered parts that looked like they were needed for the current jobs, but repaired and used the damaged parts, keeping the new part for their own use.
With the lack of a order verification system, it was not possible to check whether these purchases were legitimate or not. Needless to say, these panel beaters had very good looking cars.
Lessons to be Learned
1. Stock is not safe from theft by employees.
2. There are numerous ways for employees to hide such losses, including falsifying the sales records and manipulating the purchases records. These frauds attack the inventory records indirectly, using falsely produced source documentation.
3. Physical security protects assets. If the thieves cannot get to the assets, the chance of them stealing them is reduced.
4. Physical security of inventory can be overcome if the theft of the item occurs when the item is either purchased or sold. These frauds attack inventory that has not yet been recorded in the inventory system.
5. The records and systems that are put in place to protect inventory can be manipulated and proper controls will need to be implemented.
Prevention and Detection
Some things to look for
(i) Review sales and freight records to ensure that all inventory freighted inwards or outwards is matched to a sales or purchase invoice, and visa versa. Freighting of inventory to an outside location may be a theft of inventory in progress.(ii) Review inventory going into the freight area with inventory actually being freighted. This area may the staging area for theft of inventory.
(iii) Increasing bad debts may be a sign that inventory is being stolen and booked as a sale. The sale will later be written off. Reviewing noncurrent debtors may highlight a trend indicating this fraud.
(vi) Review shipping records for matching addresses or addresses of employees, especially if a third party shipping agent is used.
(v) Review purchases to determine whether they can all be traced to actual inventory. If the inventory items cannot be located, a purchasing scheme may have been used to steal these items.
Some basic controls
(i) There should be a purchase order for all purchases. These documents should be consecutively numbered so that they can be accounted for during audits. The invoice that is received should have that purchase order number recorded on it.(ii) Separation of duties. The person that approves the invoice for payment should not be the person that gave the order. The receipt of materials into the perpetual records should also be done by another person. A copy of the receipt document should be attached to the invoice, and approved against the order.
(iii) A similar process should be implemented in relation to the sales process. The ability to cross reference documents that have been produced and approved by a variety of people eliminates some of the avenues for falsifying these records.
(iv) Increased physical security, by limiting access to all but essential employees and only during business hours can limit inventory losses. Without the opportunity to get their hands on inventory, employees (and outsiders for that matter) had very limited circumstances to steal inventory.
(v) Physical Security should also include proper documentation to gain access to relevant inventory. If these documents are recorded against the release of inventory, all inventory transfers will have to be accounted to people and documents.
(vi) Proper and verified stock-takes as they may be the only way that you will ever determine that stock is missing. Perpetual records are only an active control if they are compared against physical stock-takes on a regular basis and discrepancies are investigated.