Tuesday, October 11, 2011

Inventory Theft: Prevention and Detection

By James S. Peet, Ph.D., CFE

One of the issues facing most shipping operations, but particularly breakbulk, is that of inventory theft. While theft of breakbulk cargo has been reduced with the introduction of containerization, it has not been eliminated. Nor will it probably ever be. All one can do is to establish controls to reduce its incidence.

According to the Association of Certified Fraud Examiners' 2010 Report to the Nation, inventory theft is listed as a non-cash asset misappropriation scheme, which cost companies, on average, $90,000. In the transportation and warehousing industry this type of theft accounted for more than 25 percent of all cases, with almost 5 percent taking place in operations/inventory with a median loss of $239,000.

Many breakbulk operations that have warehouse or transfer loading operations are prime targets for internal theft. If the shipping firm is small, that increases the odds that inventory theft will occur. The reasons for this are usually a lack of established fraud controls and policies, and the simple matter that in smaller firms there is usually a greater degree of trust because everyone knows everyone else. Theft from smaller firms can oftentimes lead to a firm going bankrupt.

It’s common knowledge that an ounce of prevention is worth a pound of cure. Toward that end, the first step in preventing inventory theft is to let employees know that you’re serious about the matter and will take strong action against them if they are caught stealing. The fear of getting caught is one of the strongest deterrents. Nobody wants to be embarrassed in front of his peers and coworkers and considered a common criminal.

Fraud Policy
The best way to inform employees is through the development and distribution of a fraud policy. This policy should be in writing and should be read and signed by every employee (including the CEO, the COO, and the CFO).

The policy should clearly describe the actions that will be taken against employees who commit theft (or any other type of fraud). Actions can be as limited as an oral or written reprimand for a first offense up to termination and prosecution.

Another way of preventing and detecting inventory theft is through the use of surveillance. Surveillance can be conducted through either the use of surveillance cameras, undercover operations, distant surveillance, or a combination of any of these.

Care should be taken in placing surveillance cameras, as courts have ruled that employees have a certain expectation of privacy in certain places – so you would not want to place them in bathroom stalls or similar settings (despite the fact that goods can be concealed while in the head).

Undercover operations and distant surveillance usually use trained personnel, either from within the firm or from private firms. If using private firms, be sure that they are properly licensed according to their jurisdiction (for example, anyone conducting surveillance for a fee in Washington State is required to have Washington State-issued Private Investigator’s license). If you break the law while having surveillance performed you may be criminally and civilly liable.

Red Flags
Red flags are indicators that something is amiss. With inventory theft, some of the red flags include the obvious – inventory shrinkage, fictitious inventory, employees seen walking off the property carrying inventory (you would be surprised how common this is) and an excess of damaged goods. Some is not so obvious, but is easily uncovered, such as an audit showing more inventory is coming in than going out/being sold, or business is up but revenues are flat or down.

Identify Problem Areas
The first step in solving any problem is to identify it. If you have evidence of any of the above red flags, you need to determine if that is the case and investigate it.

A simple (but time consuming) method in inventory control is to validate inventory by performing an unscheduled, unannounced physical count, preferably using an external auditor (one not involved with the company and has nothing to hide). Be sure to check boxes to ensure that they hold the correct inventory (you’ll probably find some empty boxes stacked behind full boxes). In fast moving transloading or breakbulk operations you’ll need to identify where the potential losses can be readily hidden prior to conducting the audit.

Another option is to engage a fraud examiner to conduct a fraud examination. Fraud examination is a methodology for resolving fraud allegations from inception to disposition. The ACFE provides a list of Certified Fraud Examiners (CFE’s) who can perform these functions. Different from an auditor or CPA, a CFE is trained and experienced in detecting and investigating fraud, which includes collecting evidence for purposes of litigation (i.e., a CFE is prepared to go to trial).

A fraud hotline is one of the best ways to catch fraudsters. According to the ACFE’s Report to the Nation, more than 40 percent of all fraud was initially detected through a tip, three times as much as by any other method (internal audits uncovered less than 14 percent). Most tips usually come through a hotline.

While larger shipping firms and ports have the finances available to set up their own hotlines, what can smaller firms without the funds do? One option is to outsource the job. EthicsLine (http://ethicsline.com/) is the official hotline of the ACFE. It offers fraud hotlines via telephone, the web, and web connected mobile devices, such a Blackberry, iPhone, and Android. For firms under 500 employees the annual cost is approximately $2,500. If you think $2,500 a year is expensive, consider the alternative (up to 5 percent loss of annual revenue due to fraud).

When implementing a hotline, be sure to advertise monetary rewards for cases that result in action or prosecution. Interestingly enough, the proven maximum payment for any tip should be no more than $1,000. For some reason, anything more than that will lead to a decrease in hotline tips.

The fraud hotline should also allow for anonymous tips. This provides the tipster with the security of knowing that they will not have any retaliation against them for reporting the crime.

A hotline will only be successful when employees are aware of it. Ways to educate employees include discussions at staff meetings/training sessions, placing posters in highly visible locations (this also gives your customers the feeling that you take the issue seriously – always a positive marketing technique), including flyers with paychecks (if you still issue paper paychecks) or paystubs, notifying employees when having them sign the fraud policy, and providing them with refrigerator magnets. The hotline material should always include the phone number, the fact that tips can be anonymous, and mention of rewards.

While impossible to eliminate, the establishment of a few controls can greatly reduce the incidence of inventory theft, leading to increased efficiency and adding to a company’s bottom line.

James Peet, a Certified Fraud Examiner (CFE), is the principle manager of Peet & Associates, LLC, a fraud examination business located just outside Enumclaw, Washington. He is a graduate of two law enforcement academies and has earned a BA at the University of Miami, an MA from California State University, Hayward and the Global Trade, Transportation, and Logistics Certificate, as well as a Ph.D. from the University of Washington.