Always the Last to Know? How to Detect and Prevent Fraud – March 22, 2013 by Keith Klodnick

Fraud can have a serious impact on a business; and, unfortunately, many companies are ripe for the taking. Owners and management need to be acutely aware of the warning signs and prevention methods that will help reduce the risk and impact of fraud.

According to the Association of Certified Fraud Examiners (ACFE), fraud costs any given entity an estimated 5% of its revenues each year. Private companies are reported to have a median loss of $200,000/year, with even greater losses reported when broken out by industry per year: $375,000 in real estate; $300,000 in construction; $250,000 in oil and gas; and $200,000 in manufacturing.

What makes a company an easy target? The ACFE sites weak internal controls as the culprit for 74% of fraud instances. Typical “fraudsters” are males ages 35 to 45. Expense reporting is an area of “opportunity,” including double reporting and the usage of fake receipts. (There are even websites that allow individuals to create and order their own professional-looking fake receipts.) Paying invoices to fake vendors is another way employees can skirt the system. Additional areas ripe for fraud include payroll, vendor and customer kickbacks; employee incentives (e.g., pay incentives for sales, profits, gross margin, attendance record, no injuries, etc.); bribes; stolen inventory or fixed assets; and the abuse of company credit cards.

Detect It

The ACFE reports that management review and internal audits each account for approximately 15% of detected cases. Management and owners need to take a more active role in identifying fraud early on. Look for some of these key red flags:

  • Questions regarding management integrity
  • Management emphasis on meeting projections and goals
  • Frequent disputes with accounting firm
  • Weak internal control environment
  • Management compensation heavily tied to operational results
  • Receivables and payable increase while sales and profits decrease
  • Low employee morale/motivation
  • Operation and financial decisions controlled by one person or small group
  • Management and key personnel turnover is high
  • Frequent and unusual transactions just prior to end of accounting period
  • Line of credit drawn to maximum for extended periods of time
  • Significant acquisition activity
  • Frequent and significant complex transactions
  • Abnormal changes in account balances
  • Shortages in cash, investments, inventories or other assets
  • Supporting documents altered or missing
  • Unusual write-offs
  • Complaints from customers about their accounts
  • Incomplete financial data
  • Infrequent or late financial reports
  • Large liabilities related to unexpected contracts
  • Vendor lists that show duplicate vendor names, or very similar names, or addresses
  • Vendor invoices with the same numbers or are in sequential order (unless you happen to be this vendor’s only client)
  • Failure to correct internal control deficiencies noted in prior periods
  • Sudden departure of personnel in key positions
  • Appearance of personnel living beyond their means

Also beware of the “perfect employee.” While every business owner wants to trust his or her employees, be mindful of an employee, particularly one with access to the company’s financial information, who often comes in early/stays late, takes on additional responsibility, rarely complains, earns management’s trust, is unusually attentive to customer complaints, and has personal financial troubles that are suddenly resolved.

The ACFE reports that tips make up 43.3% of detected fraud cases. Since most tips come from employees, vendors, customers and other sources close to the business, an easy way to help encourage suspicious activity reporting is to offer an anonymous, third-party reporting hotline.

Prevent It

Prevention is, of course, the best case scenario when it comes to fraud. Management and owners can help stop fraud before it starts by remaining aware, present and diligent:

  • Run background checks prior to and during employment. Background checks are critical for employees obtaining positions of trust. Be mindful to have the potential employee sign a release form authorizing credit and background checks throughout the tenure of employment.
  • Compel employees to take vacation. Having someone temporarily fill in for an employee is a good way to find suspicious activity.
  • Pay attention to an employee’s changes in his or her personal and financial life. Note when an employee buys a new car, big house, etc. that seems inconsistent with their salary and general manner of living.
  • Secure fidelity bonds on employees who are entrusted with money.
  • Add an ethics policy and let employees know they will be prosecuted if they commit fraudulent acts.

Take a Hard Look

One of the hardest, yet most important, things to do in the prevention and detection of fraud is for business owners and management to look at themselves and how they run the business. Do we have the right policies in place? Are they clearly communicated to employees? What else can we be doing? Ask these 10 questions to begin reducing the risk of fraud:

  1. When was the last time we reviewed our internal controls?
  2. Are all of our employees bonded?
  3. Are the volunteers who sign checks, transfer funds, or otherwise have
  4. access to significant assets bonded?
  5. Do we have a fraud policy statement in place?
  6. Do our employees know what is expected of them ethically?
  7. What procedures do we use when checking potential new hires?
  8. Who is looking for unusual fluctuations in our financial records?
  9. Do we keep an eye out for unusual employee behavior and dress?
  10. When will we speak to our auditors next about our internal controls?
  11. Do we have clear written policies and procedures for each staff position?

For more information, contact Keith Klodnick at kklodnick@cohencpa.com.

This communication is for information only, and any action should only be taken after a detailed review of the specific situation and appropriate consultation.

Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.