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Understanding Internal Fraud in the Manufacturing Industry

Posted by Jason Cope, CPA on Sep 9, 2019 9:10:00 AM

Would it surprise you to learn that the manufacturing industry is second only to banking in the number of global fraud cases a year?

No business owner wants to believe that their employees would steal from them. Fraud cases that make news headlines tend to be substantial embezzlement cases at large corporations involving tens of millions of dollars and higher. Yet, fraud can happen at businesses of all sizes and among employees at all levels.

Why Do Employees Steal?

It can be helpful to understand what motivates an employee to commit fraud. Knowing as much as you can about your employees can be extremely helpful in spotting red flags. If someone acts or spends in uncharacteristic ways, for example, it may be worth your attention.

In many cases there is a perceived economic need—employees have financial needs or aspirations that surpass their paychecks, such as economic hardship due to illness, divorce, debt or other emergencies. Other times it’s just pure greed—the desire for expensive autos, clothes, homes. The list is endless.

However, opportunity is another leading reason for fraud, especially given the high volume of inventory in the manufacturing process and the number of employees with access to it. There’s simply more opportunity for fraud, especially for asset misappropriation.

Sometimes the technical ability of a fraudster who has access to your systems creates another type of opportunity. Some employees rationalize that the company won’t miss a small amount of theft. However, that small amount can quickly accumulate, and before they know it, they are committing continuous and costly fraud.

The implementation of internal controls can help. For example, manufacturers can review production costs and inventory more frequently and examine overhead costs charged to inventory.

Fraud is more likely to occur when there is insufficient security over company property, weak internal controls and a low likelihood of detection due to unclear or unenforced policies. In other words, people commit fraud because they feel they are “allowed” to do so. The following examples illustrate this point.

Expense Report Fraud

The ACFE report underscores that expense report fraud is one of the most frequently committed types of fraud, costing businesses tens and even hundreds of thousands of dollars. From not providing appropriate expense report substantiation to creating fictitious documents and altering documents, employees abusing expense reimbursement are creative, and their patterns can take up to two years to detect. While no industry is immune to it, expense reimbursement fraud is more prevalent in certain industries – including manufacturing – and at companies with fewer than 100 employees. In the U.S., expense reimbursement fraud makes up 17% of all frauds.

Keep in mind that senior level employees are just as likely to engage in internal fraud. Manufacturers can decrease opportunities for expense fraud with a very clearly defined travel and entertainment expense policy with strict enforcement measures, including mandatory documentation. 

Credit Card Abuse

Corporate credit card abuse is a growing problem because it can involve millions of dollars of theft over a number of years. If internal controls are weak or nonexistent, executives and sales representatives, among others, charge items to the company that are not business-related, or they simply inflate the amount of their expenses. Some businesses opt to require employees to use personal credit cards and then provide full substantiation for the expenses. Your employees should fully understand your company’s policy with regard to permissible charges.

Again, a well-documented travel and entertainment policy can be your best defense. All credit card statements should be reviewed by internal accounting personnel. Credit card statements should be reconciled on a timely basis and be performed by someone other than the employee who has the authority to write checks.

Fictitious Vendors

Payments to fictitious vendors occurs when an employee creates an invoice for payment by the internal accountant or controller for goods that were never received or services that were never rendered. In the rush to get bills paid, fraudulent invoices are overlooked. There should be red flags, such as discrepancies between purchase orders and invoices; round numbers; an unusual increase in invoice volume; and more. Who at your company is checking to ensure that the vendor is legitimate? Do you have due diligence in place to verify the vendor is in your system?

It’s possible that the vendor doesn’t even exist, and that the address is made up. Fictitious vendor fraud can be thwarted with your vendor setup procedures in your accounting system. Most important, avoid having one person responsible for the entire vendor setup and payment process. You don’t want to give a single person unquestioned authority over your entire financial processes.  

Now, that you’ve learned about some of the leading types of fraud that may take place in the manufacturing industry, you may wonder what you can do about it. Fortunately, there are controls you can either strengthen or put in place to proactively manage your risk.

Download our free nine-page e-book: How Manufacturers Can Reduce Fraud Through Stronger Internal Controls.New call-to-action

For more information about internal controls for your manufacturing business, please contact Jason Cope, CPA, at 214-635-2546. Learn more about the Manufacturing and Distribution Services Group at Goldin Peiser & Peiser.

Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.

Topics: Manufacturing, Fraud