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In this lesson we are going to talk about fraud.
Fraud is a broad concept and necessarily so,
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but at its core is a breach of trust by an
employee,
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which results in an unauthorized
misappropriation of assets or misrepresentation
of information.
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These criminal actions result in either a direct or
indirect benefit to the employee.
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That’s a mouthful just say, so let’s slim it down
some.
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Employees who lie, steal, or use their job for
their own personal gain are committing fraud.
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In this module, I’m going to break the discussion
into three different lessons.
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First, let’s learn about the types of fraud.
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Next, let’s learn about why and how fraud
happens.
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Finally, we will do something about it to either
prevent or detect it.
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So to begin with, to engage in a discussion
about the types of fraud you need a lot of time
and mental capacity.
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Why?
Because frauds have so many variations.
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It’s far more sinister than simply stealing cash
out of the register or stealing inventory from the
warehouse.
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Let’s see if we can bring some structure to our
understanding of fraud.
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First, let’s only deal with employee fraud in this
module, that is- fraud that arising from an inside
job.
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There are other frauds that can be committed by
those outside the organization, but that’s
separate discussion.
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Next, let’s break employee fraud into three
different categories.
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Misappropriation of assets, which you can think
of as theft.
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Secondly, Corruption, which happens when an
employee abuses their position within the
organization.
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And thirdly, reporting fraud, which comes from
lying about what really happened.
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Asset misappropriation is by far the most
common type of fraud.
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In fact, it may be a bit presumptuous in such a
statement,
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but I believe this sort of fraud happens in just
about every organization that exists.
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Let me explain what it includes and then you
decide for yourself whether I’m overstating the
risk.
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As we said earlier, think of theft and stealing
when we talk about asset misappropriation
schemes.
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Let me identify some of the most common
schemes to give you an idea of what I'm talking
about.
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And we will look at these scheme on an asset
by asset basis.
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Cash is obviously the most susceptible to theft.
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One such scheme related to the theft of cash is
called skimming.
Skimming is a fraud whereby
an employee receives,
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and pockets the cash from a customer before it
is ever recorded by the company.
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Employees can also steal cash after it’s been
rung into the register by reversing sales or
recording a fraudlent return.
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Cash can also be stolen later in the process
through a scheme called lapping.
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Here an employee receives customer payments
and pockets the cash.
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The employee can conceal the theft because
they have the ability to also adjust the receivable
subledger.
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They may choose to write the account off
directly to an expense account like a bad debt
expense,
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or wait for the next customer to make a
remittance,
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and apply that payment to the previous
customer whose payment they pocketed.
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Cash can also be stolen through payment
schemes to fictitious suppliers or for fictitious
invoices.
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Fraudulent payroll schemes can also extract
cash from the company by paying fictitious
employees,
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or paying a bonafide employee for hours that
haven’t be worked or at an incorrect rate.
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Check tampering techniques are a way of
extracting cash directly from the bank account...
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by intercepting or forging cheques of the
company.
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Finally we have expense claim fraud is, which is
extremely common with lots of variations,
though often involves small amounts of money.
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Employees may pad expenses by submitting
fictitious expense claims or duplicate claims or
fictitious milage- there are many variations.
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Let’s move on to spend a moment talking about
inventory fraud.
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Inventory may have value on its own or be
readily sold to realize cash.
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Inventory theft happens in a variety of ways, it’s
the cover up that gets tricky.
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If the thief has access to adjust the inventory
records that makes it easier.
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For certain entities, like retail stores, theft
simply gets accumulated with other shrinkage,
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and may be impossible to attribute to a
particular individual.
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Fixed assets which can also be susceptible to
theft, particularly small items like laptop
computers and other technology devices.
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Little attention is often paid to old equipment or
equipment that is fully depreciated.
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Intangible assets are often not considered in the
context of fraud, but pose a significant risk to
many organizations.
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Confidential information of the company may
have value and employees with access can
exploit this value for personal gain.
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Misappropriation schemes also include
unauthorized use of company assets.
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Some examples might include using
telephones, computers, or company stationary
for personal use.
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And while perhaps it’s not fraud per se, skipping
work or not reporting vacation days is still wrong
in any context of the ethical code of behavior.
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Misappropriation schemes collectively are the
least material and most common of the fraud
schemes,
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but can still add up to a substantial loss over a
long periods of time.
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Fraud statistics accumulated by the ACFE,
estimate the average loss from such schemes
that have been brought forward...
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to be $135,000 over an average duration of 18
months before they are detected.
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I was reading an article the other day where a
controller of a small U.S. city managed to steal
$30 million from the city and the state...
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over the course of three decades before getting
detected.
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The second group of fraud schemes I will
discuss are under the banner of corruption.
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Bribes and illegal gratuities are monies or
payments in kinds received by the employee
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from customers or suppliers for special
consideration.
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In the world today, there is over $1 trillion in
bribes paid out each year.
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Well this practice is less prominent in the
developed countries, in the third world countries,
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paying bribes to conduct business is considered
normal practice.
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This obviously raises ethical issues for multi-
national companies.
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Extortion is somewhat different than a bribe in
that the employee will approach the vendor or
the customer,
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and threaten them with losing business with the
company if they don’t pay him off.
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A conflict of interest arises when an employee
is not dealing with a customer or supplier on an
arm’s length basis.
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Perhaps they have a direct or indirect financial
interest in the customer or supplier.
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The problem is that when this happens, the
company is not likely to extract the best value
from the terms of the relationship.
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And lastly, the third category of fraud schemes
is financial reporting fraud.
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This is the most complex type of fraud and also
results in the greatest loss in value to the
organization.
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ACFE stats suggest that losses for these types
of cases average $4.1 million.
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Financial reporting fraud can be driven by
individual or corporate interests.
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Individuals may have performance bonuses,
stock options, or share interests that are driven
by corporate results.
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Individuals may also feel pressured to conjure up
fraudulent reporting for corporate purposes as
well to meet analyst expectations,
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maintain the corporate reputation, or comply
with lending covenants.
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These schemes are often perpetrated by senior
management.
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Senior management uses its authority and
access to override processes and controls.
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They may adjust revenues, inventories or
underreport liabilities by posting journal entries
or engaging in transactions...
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designed to window dress the financial
statements.
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For example, senior management may ship
extra product to customers just prior to year end
to...
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bolster sales with an unwritten arrangement with
the customers allowing them to return the
unsold product at a later date.
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This is a scheme called channel stuffing.
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Some reporting schemes don’t involve the
accounting numbers at all,
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but instead fraudulently report other important
information to stakeholders.
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For example, Bre-X was a Canadian gold mining
company that reported the discovery of
substantial gold reserves...
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that were later found out to be a hoax causing
shareholders to lose billions of dollars.
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I leave our discussion of the types of fraud at
that for now,
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but you can appreciate that there are a lot of
different ways fraud can happen.
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If you are still doubtful that fraud can be
happening in your organization, consider the
words I heard from one fraud expert.
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He called it the 20-60-20 rule which goes as
follows:
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20% of the people in your organization will be
honest no matter what.
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20% of the people in your organization can be
expected to exploit any weakness the
organization has for their own personal gain.
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However, the real risk lies with the 60% of folks
in the middle, who are generally honest,
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but under the right circumstances would
perpetrate a fraud.
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In our next lesson, we are going to understand
what those circumstance are.
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Until then, don’t stop until you get to the top and
when you get to the top, don’t stop.