Physical Theft In The Workplace

Physical Theft In The Workplace

By Steve Lee, Managing Director
www.stevelee.com

September 15, 2009...What are the components of physical theft effecting enterprises? We're talking about larceny, embezzlement and misapplication. Black's Law Dictionary defines "larceny" as the "felonious stealing, taking and carrying...away another's personal property with intent to convert it or deprive the owner thereof." When an employee or another person unlawfully converts or removes one's property for his own benefit, the crime is embezzlement. When it's done for the benefit of someone other than the wrongdoer, it is misapplication. In all cases, it's theft.

While cash theft schemes occur three times more often than non-cash (inventory and other assets) theft schemes there is still plenty to talk about with these non-cash theft schemes.

So what are the big targets for physical theft?

That depends upon the industry in question.

If a company is in the healthcare space, there is a raging market for pharmaceuticals, medical equipment and related paraphernalia (not to mention scheduled drugs). According to the Association of Certified Fraud Examiners, hospital admission kits are high on the list of items subject to employee theft.

The good news is that most non-cash larceny schemes are not very complicated. Hourly workers like warehouse personnel with access to inventory or supplies typically perpetrate these crimes. More often than not, employees walk off with company assets in plain view of their coworkers. Here comes the trust issue. Most coworkers believe that their coworkers (who may have become friends or acquaintances) are acting in good faith. When they see their acquaintance walking an asset out of the work place, they assume he has good cause and authorization to do so. We tend to find less controls in private companies than in public companies and it is perhaps for this reason that personal trust becomes a greater problem in private firms. As a side note, it’s an interesting commentary on our times, our culture and our economy that I can string together the words “personal trust becomes a greater problem” without embarrassment.

What do these non-cash theft schemes look like? For what vulnerabilities must you heighten your awareness?

We all know that theft occurs right out of the warehouse. An employee who steals the company’s warehouse merchandise is stealing an asset the company needs for its business. These assets are meant to be available for a particular purpose like satisfying customer needs. And of course, in their absence, the company loses revenue.

Then there is larceny of inventory. Asset misappropriations are not always perpetrated by employees acting alone. Corrupt employees may work in concert with outside accomplices to steal inventory. Certainly, the fake sale is one method that is accomplice dependent, and it happens tens of thousands of times per day! The fake sale is simple and easy to accomplish. The outside accomplice "buys" merchandise from the employee. The employee does not “ring up” the sale.

However, there are more complex schemes than just walking out the door with merchandise or failing to enter a sale into a register.

How about personal purchases with company funds? In this tried-and-true classic, the fraudster purchases personal items with the company's money. Company accounts are used to buy items for the wrongdoer, for their side business and their family members. Here our crook buys an item and submits the bill to his employer as if it represented a purchase on behalf of the company. His objective is to have the company pay the invoice. We call this a fraudulent billing scheme rather than a proper theft of inventory. The company is still deprived of inventory or physical assets, but the central point of this scheme is not the taking of existing inventory, but the purchase of new inventory that the company will never receive. From the company’s perspective, this asset is not central to its business as it is when employees make off with warehouse merchandise so the damages amount to the money lost in purchasing the item that struck the wrong-doer’s fancy. What does this kind of crime look like? The company may have an employee that has control over the purchasing function at a company. He can, on his own authority, purchase thousands of dollars worth of power tools or equipment for use in his home or in the handy man business he runs on weekends.

But there are worse purchasing and receiving schemes. Crooked employees manipulate the purchasing and receiving functions of a company to enable and cover-up the theft of inventory and other assets. Here is how it often works. An employee is responsible for receiving goods on behalf of the victim company. He could be a warehouse manager or a receiving clerk or a “delivery” man. He falsifies the records of incoming shipments. Suppose that 100 smart phones are received. The dishonest employee notes that 90 were received. By marking the shipment short, he enables the theft of ten smart phones. The ten phones never make it into inventory.

If they do make it into inventory and our employee simply takes them home, then we have inventory shrinkage. Inventory shrinkage is the unaccounted for reduction in the company’s inventory that is the product of theft. Some crooks will try to cover up inventory shrinkage. Empty boxes, full bottles replaced by empty bottles, blister packs filled with sand or with obsolete equipment rather than the equipment that is supposed to be in the package are all favored techniques. There is a famous case from a generation ago of a company in the salad oil business. The salad oil was kept in huge vats. The vats were filled with water except for a long metal tube that was fitted to the top testing port. That tube was filled with salad oil. When auditors inserted testing tubes into the salad oil vats, they appeared to be full. This was not an early and unsuccessful attempt at diet salad dressing but rather a clever theft of the company’s product.

In one of our fraud cases, the owners of a company perpetrated a massive inventory fraud. One element of the fraud included buying and selling the same computer processing units (CPUs) together with their heat sink fans over and over again. The company would sell these blister-packed twinned units to a related party who would sell them to another related party and so on until they were purchased back by the same company that originally sold them! The extraordinary thing was that from the beginning the owners of the company had removed the CPUs from the blister pack, resealed the packaging and simply shipped them with nothing but the fan. Of course, the fan was 99% of the weight and volume of materials in the blister pack. Even upon casual inspection, auditors did not notice the missing CPUs. But the CPUs were 99% of the value in the package. That fraud went on for years until we surfaced it. To top it off, the company sold the CPUs to an outfit in China that was making illegal clones.

Back to shrinkage and how to conceal it. A straightforward method is to change the perpetual inventory record so that it will match the physical inventory count. We call this a forced reconciliation. The bad guys do nothing more than change the numbers in the perpetual inventory to match the actual inventory count.

In fact, we frequently see wrongdoer employees writing off inventory and other assets in order to remove them from the books after the theft. The more aggressive fraudster writes off the inventory before it’s stolen. Who, after all, will miss the inventory after it has been written down to zero? This fraudulent technique greatly reduces shrinkage, so it is widely employed. Let’s go back to our earlier example of selling merchandise without recording a sale. This increases the inventory shrinkage on the company's books because the actual inventory is reduced without a concomitant reduction in the perpetual inventory record.

How do you detect the various species of physical theft?

One method is analytical review. Inventory fraud can be detected through trend analysis. The Association of Certified Fraud Examiners points out that when the cost of goods sold increases by a disproportionate amount relative to sales, and no changes occur in the purchase prices, quantities purchased or quality of products purchased, the cause of the disproportionate increase in cost of goods sold might be the depletion of the ending inventory by theft.

Chances are that the numbers will not pass the smell test. Something will seem wrong. It’s generally an experienced forensic investigator who is going to do the detection.

How do you prevent the various species of physical theft?

This is about the company’s control environment and its training, awareness, policies and technologies. What do we mean by controls environment? We’re talking about policies and practices, independent observation of inventory, segregation of duties, substantive pre-employment screening, verification of shipments and receiving logs, obtaining sufficient third party evidential material regarding deliveries, two-person control, radio frequency tags and monitoring on inventory, surveillance and security, enforcement of security and area restrictions, limitations on the distribution of keys, key cards and door lock combinations, enforcement of vacation policies, rotation of responsibilities, internal audit and so on. Also, consider doing what trustees do when they take over businesses. They change locks. It’s often a good place to start if you don’t hand out keys like candy.

It’s 2009. If an owner or manager of a business is experiencing high levels of employee theft, it’s because he hasn’t put the right people and controls in place. And that means he has decided – even if only passively – that the cost of prevention exceeds the likely losses. But that’s an incorrect assumption. According to the Association of Certified Fraud Examiners in their most recent Report to the Nation, the median damage for private companies suffering from non-cash misappropriate schemes is in the neighborhood of a quarter of a million dollars. A great deal of prevention can be bought for a fraction of that amount.

Asset based lenders – those who advance funds against receivables and inventories – have an old saying when they go into a credit that doesn’t quite pass the initial sniff test: “Keep your hands on your wallet and your eyes on the back office.” It’s good advice for business owners too.

About Steve Lee & Associates

Steve Lee & Associates (SL&A) is among the foremost companies involved in worldwide high-stakes litigation and forensic accounting work. Much like an economic swat team, this cadre of highly skilled professionals solve complex commercial matters in areas such as corporate and fraud investigations, loan workouts, insolvency and reorganization, electronic discovery, computer security, competitive intelligence, class action defense, transaction advisory services and theft of intellectual property. Headquartered in Los Angeles, with offices in New York, Chicago and London, SL&A has operated in more than 50 countries across the globe. Additional information about Steve Lee & Associates can be found at www.stevelee.com.