January 2009

Employee Theft and its Impact on Retailers
This article is re-printed with the permission of The American Bar Association. Copyright © 2008 by the ABA. The original title was "Employee Theft vs. Inventory Shrink in a Fidelity Loss".

For more information about the ABA, please go to http://www.abanet.org/.

Whether you're a titan of Wall Street, an assembly worker from the Motor City, a bank vice president, a homeowner upside down on his mortgage or just an average person with a pretty normal life, one thing is certain: the downward spiral of the economy has all of us wondering what will happen next.

During these trying economic times, there are unfortunately those who – either out of desperation or greed – turn to illegal or dishonest activities in an attempt to extricate themselves from a difficult financial situation or simply just survive.

No matter the motive, there is little doubt that instances of fraud and theft are on the rise. Retailers, in particular, are certainly among the hardest hit during the financial downturn. They are faced with the reality of retail shrinkage ("shrink") due to inventory losses occurring from employee theft, shoplifting, organized retail crime, administrative error, and vendor fraud.

According to the National Retail Security Survey for the year 2006, retail losses due to shrink reached $40.5 billion. Approximately 47% of this amount was attributed to employee theft.

The 2006 Report to the Nation on Occupational Fraud and Abuse, published by the Association of Certified Fraud Examiners, Inc. (ACFE), states that 91.5% of all cases included in the report were asset misappropriation cases. Asset misappropriation can be broken down into two categories: cash misappropriations and non-cash misappropriations (Table 1). Non-cash misappropriations include theft of inventory. The median loss for an inventory theft is estimated at $55,000. Inventory thefts account for approximately one-sixth of all asset misappropriation schemes documented in the ACFE report (See Table 2).

As these statistics reflect, the risk of loss due to employee theft of inventory is significant. Understandably, many companies purchase fidelity insurance to pass this risk on to an insurance carrier. This article attempts to explain how a fidelity insurer can separate employee theft from total shrink in analyzing a claim.

Shrink is usually calculated by comparing a physical inventory count to the count recorded in the company’s financial records. Any discrepancies are recorded as a shrink loss. A company generally cannot explain why a product is missing or exactly when it disappeared. A shrink account is similar to a cash short/over account.

Consider a single container of yogurt. If you buy 10 of them at the grocery store, but the cashier only rings up nine, this is employee error, and will show up as shrink. Perhaps you are buying 10, but you accidentally only put nine on the counter. The other got stuck under your crying child’s car seat in the cart. You don’t realize your mistake until you get out to your car. This also is reflected as shrink. If the yogurt container falls from the counter and breaks, again this is reflected as shrink. If the cashier’s girlfriend comes through his line and he intentionally opts not to charge her for one container of yogurt, this is both shrink and employee theft, but most likely will never show up as anything other than shrink. If, however, they do this four days a week, 50 containers each time (she resells the yogurt to the deli down the block), it likely will be noticed.

Why? Frequency, regularity, and amount -- these tend to be the hallmarks of employee theft. Generally (but not always) the more expensive the inventory, the more likely its loss will be detected. It may take supermarket months to notice extra yogurt moving off its shelves, but an electronics company typically will notice the theft of expensive televisions much more quickly. Of course, how quickly any employee theft is detected will depend upon the quality of a company’s internal controls.

One of the most important steps in evaluating a claim involving employee theft of inventory is to determine the amount of the loss asserted and how that amount was calculated. The first check is to confirm that the insured is claiming theft of inventory at the insured’s cost and not retail price.

The loss claimed by the insured must be linked to the theft of particular assets. The insured may attempt to present a claim that simply identifies the total shrinkage reported in its financial statements during the period of employee’s employment. This is not sufficient, and would almost certainly result in a denial of coverage. In fact, most fidelity bonds expressly preclude proof of a loss merely through identification of an inventory shortage.

As an example, consider the hypothetical claim from a manufacturer of high priced technology items, alleging a $50,000 loss resulting from employee theft. The company observed an employee misappropriating certain items (based on video and employee statements) and subsequently provided an inventory discrepancy (shrink) report totaling $50,000 for the period of the principal’s employment. An analysis of the report and supporting documentation, however, might reveal that $20,000 of the discrepancy was due to a timing difference in the recording of inventory (items in-transit to a customer that were not properly recorded as having been sold), and another $10,000 worth of items actually were taken to the insured’s quality assurance center for testing. The potential maximum loss thus has been reduced to $20,000. This example is the result of an analysis of a shrink report and demonstrates why fidelity policies typically do not allow losses to be established from inventory computations. Further analysis of the $20,000 would be required to distinguish potential employee theft from normal shrink.

Another example would be if an employee is suspected of stealing a certain product stored near a door in a warehouse. Attention would be focused on all of the products stored in the vicinity of that door. If evaluation of the shrink rate of those products as compared to the general inventory was much higher, then there may be circumstantial support for the contention that employee theft caused the shrink of those specific products (adjusted for normal shrink.) Normal shrink for those products should be calculated using data prior to the suspect’s hire date or the date the suspect transferred to that department.

But there are exceptions to the inventory shortage exclusion. For example, the new ISO Commercial Crime Policy (CCP) Form, CR 0022, effective in 2006, contains language excluding coverage for loss (or that part of any loss) upon which proof is dependent on an inventory computation. The policy then goes on to read: "However, where you establish wholly apart from such computations that you have sustained a loss, then you may offer inventory records and actual physical count of inventory in support of the amount of loss claimed."

A claims handler will need to review the documents provided and request that the insured quantify the theft, with an explanation of the method used to measure the loss and when exactly each theft occurred (or is believed to have occurred). It often is difficult for the insured to directly prove that the suspect is the perpetrator, absent law enforcement’s involvement. Therefore, the insured will need to assist the insurer in eliminating other possible suspects and other possible explanations for the missing inventory.

Although many fidelity insurance policies do not require that the police be notified when employee theft is discovered, the insured should bring in local law enforcement to investigate and help answer the questions: When? Where? What? How? And, importantly, who? A claims handler and an insured often may obtain only circumstantial evidence in its investigation, as opposed to law enforcement, which is in a better position to obtain information from an uncooperative suspect. The threat of criminal prosecution will also aid the claims handler and insured in obtaining cooperation and, in some cases, restitution, from the suspect.

If the suspect is pursued in a lawsuit, financial documents for the suspect may be subpoenaed and analyzed. This process can be time intensive. Important records to be obtained include the suspect’s bank statements, any loan agreements including provided financial information, identification of all addresses used (including P.O. Boxes), a detailed credit report (which may require an authorization), and detailed reports from any online auction website accounts managed by the suspect. If law enforcement is involved, efforts should be made to ensure that any sentence includes restitution. If the crime falls under federal jurisdiction, full restitution may be a mandatory part of any sentence. Restitution may obviate the need for civil litigation. A restitution order is in some ways equivalent to a civil judgment and may be enforceable by the victim, so obtaining a separate judgment may be little more than a "belt and suspenders" approach. The law of the particular jurisdiction must be consulted.

Fidelity policies contain many limitations that are beyond the scope of this article. Of course, a claims handler should be familiar with those limitations, such as policy period, the definition of "employee," and the definition of "occurrence" and "discovery."

Inventory thefts are a significant cause of fidelity bond claims, and claims handlers need to be aware of the various issues to be considered in analyzing such claims.

About the Authors

Daniel G. Markowicz, CPA, CVA – Partner and Patrick DeLangis, CPA, CFE, CFFA, CFF – Senior Manager

Table 1: Fraud Tree

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Table 2

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