Deterring, Detecting and
Reporting Fraud
Chad Martin, Barnes Dennig Director
Certified Public Accountant
Certified Fraud Examiner
Deterring, Detecting and Reporting Fraud
By Chad Martin, CPA, CFE
Fraud is generally defined in the law as an intentional misrepresentation of material existing
fact made by one person to another with knowledge of its falsity and for the purpose of
inducing the other person to act, and upon which the other person relies with resulting injury
or damage. Fraud may also be made by an omission or purposeful failure to state material
facts, which nondisclosure makes other statements misleading.
For our purposes in discussing fraud, we will focus on corporate fraud – which is one
person falsely using an occupational relationship with a company for personal gain.
The Fraud Triangle
Dr. Donald Cressey, one of the nation’s leading experts on the sociology of crime,
developed the Fraud Triangle model to display the three factors that must be present, at the
same time, in a situation in order for a person to commit fraud.
Opportunity
Incentive / Pressure
Attitude / Rationalization
Point 1 - Opportunity for fraud is generally provided through internal control weaknesses,
such as poor supervision and review, segregation of duties, management approval, and
system controls.
Point 2 - Incentive/pressure to commit a fraud can be imposed by personal financial
problems, personal vices such as gambling, drugs, extensive debt, etc., unrealistic
deadlines, budgets and performance goals. This is the initial motivator of the crime.
Point 3 - Attitude/rationalization occurs when a person creates justification for the fraudulent
acts such as an immediate need for money with the intention of repaying in the near future,
the company will be more forgiving than the IRS or debt collectors, and reluctance to reduce
lifestyle. They consider themselves ordinary, honest people caught up in a bad
circumstance.
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Types of Fraud
Asset misappropriations (theft) – consists of directors, employees, etc. entrusted to
hold or manage company assets who abuse their position to steal from the company.
This is the most common type of fraud (85%+), but also the lowest dollar loss
(<$150,000) per incident. Asset misappropriation schemes are classified into Non-Cash
and Cash categories.
Non-Cash schemes are typically misuse of company assets during non-working hours
or theft of non-cash assets, including purchasing and receiving schemes. This would
include items that are useful to a person or have a value to an illegal seller on the black
market.
Cash schemes fall into physical theft of cash (larceny), removing cash from sales
(skimming) either before or after the sale is recorded on the books, and cash
disbursement schemes.
- Larceny – theft of cash, bills and coins, from the company register
- Skimming – theft on cash inflow side through unrecorded or understated
sales, false receivable write-offs, and receivable lapping.
- False Disbursements – theft on cash outflow side through billing, payroll,
expense reimbursement, check tampering, and register disbursement
schemes.
Fraudulent financial reporting (cooking the books) – the falsification or omission of
amounts or disclosures in financial statements to deceive its users. This is the least
common type of fraud (<5%), but comprises the largest dollar loss ($4mil+) per incident.
Fraudulent statements are schemes to alter company financials to overstate or
understate the assets and revenues of the company in order for the company to gain an
advantage, such as a bank loan renewal or higher stock price.
Corruption (wrongful influence) – is giving or receiving an advantage through
illegitimate or immoral means. This type of fraud exists in approximately 30% of
instances and produces losses of approximately $300,000 per incident. Corruption
involves unfair advantages due to unreported conflicts of interest within a business
transaction or bribery of business associates such as kickbacks, bid rigging, and illegal
gratuities.
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Red Flags of Fraudster
A person committing a fraud usually displays certain personality traits and/or changes in
behavior. These are only warning signs which may be an indicator of a heightened fraud
risk. In no way should these red flags be considered evidence that a fraud is occurring.
Personality Traits
Changes in Behavior
- Wheeler and Dealer
- Buying more material items
- Don’t like people reviewing their work
- Carrying unusual amounts of cash
- Domineering / Controlling
- Turns down promotions
- Work performance is too good to be true - Coming in early or staying late
- Have a “beat the system” attitude
- Don’t take vacation or sick time
- Unable to relax
- Borrows money from coworkers
- Live beyond their means
- Bill collectors show up at workplace
- Strong desire for personal gain
- Exhibits dissatisfaction about work
- Rewriting records under guise of neatness - Becomes territorial in responsible area
- Quickly upset when questioned
Prevention
Prevention can take place only with the “Opportunity” point of the Fraud Triangle. It is
cheaper and more effective to prevent a fraud than to detect a crime. At the core of an
effective system of antifraud programs and controls is the overall company culture. If
integrity is not a foundational value of the company, the company may be highly
vulnerable to fraud. It is management’s responsibility to establish the company’s core
values. Management personnel should set the proper tone through their own actions
(reinforcement of core values) if they expect employees to adhere to the value system
(based in honesty and ethics) they have defined. Management cannot act one way and
expect subordinates to behave differently. Creating the right culture can positively
impact pressures employees may feel to commit fraud, thus acting as a preventive
measure.
Management should communicate the company’s ethical values orally and in writing
using a code of conduct. The company’s code of conduct should reflect the core values
of the company and guide employees to make good decisions throughout their workday.
To be most effective, the company’s code of conduct should be communicated and
reiterated regularly to all employees. A work environment should be created where
employees have a clear understanding of right vs. wrong and feel free to ask questions
about ethical issues and to report violations. In conjunction with the ongoing
communication of the code of conduct, management should consider a refresher ethics
training course. Some companies use a fraud hotline to aid employees facing an ethical
dilemma or uncertainty when applying the code of conduct to a contemplated action.
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Codes of conduct often include the following topics:
- Guidelines for employee conduct while on the job.
- Disclosure of conflicts of interest.
- Discussion of maintaining proper relationships with customers and suppliers.
- Gift and entertainment guidelines.
- Definition and examples of unethical behavior.
- Rules governing employee use of company assets for personal activities.
- Procedures for how to report fraud or unethical behavior.
To be successful in deterring fraud, a company should have a policy of hiring and
promoting individuals with high levels of integrity, especially for positions of trust and in
areas where fraudulent activity is most commonly found. Management should consider
drug screening, bonding, and/or a thorough investigation of new hires. Ongoing
performance reviews can include an evaluation of how each individual has positively
contributed to the workplace environment.
Internal control is an important deterrent to fraud. Strong internal control can prevent or
detect on a timely basis most types of misappropriations of assets and fraudulent
financial reporting. Some examples of controls are mandatory vacations and job
rotations, surveillance techniques, management review, segregation of duties,
password protection on computer files, and physical safeguards on assets.
Detecting fraudulent behavior in a timely manner and taking swift action to terminate
and prosecute perpetrators may deter other employees who might consider committing
fraud. Should a circumstance like this occur, the company should take full advantage by
clearly recommunicating management’s expectations about the consequences of
committing fraud. Knowing that other people within the company have been disciplined
for wrongdoing can be a powerful deterrent, increasing the perceived likelihood of
violators being caught and punished. It is generally the perception of getting caught that
modifies an employee’s behavior by persuading the individual to abandon the thought of
committing fraud. After an investigation, management should reassess any controls
which were circumvented that allowed the violation to occur.
There are several resources commonly found on the internet which include prevention
methodologies. Some examples are:
- Report to the Nation – fraud report issued by the Association of Certified
Fraud Examiners every 2 years.
- Global Economic Crime Survey – international corporate crime and fraud
report issued by accounting firm of PricewaterhouseCoopers every 2 years.
- Management Antifraud Programs and Controls – document issued jointly by 7
professional finance organizations.
- Key Elements of Antifraud Programs and Controls – white paper issued by
accounting firm of PricewaterhouseCoopers.
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