July 2010

Occupational Fraud: Recognizing Red Flags and Managing Risk

Businesses and not-for-profit organizations continue to be victimized by fraudulent activity,
with perpetrators constantly using evolving technology to develop new schemes

A typical company loses 5% annually to occupational fraud, according to the 2010 Global Fraud Study conducted by the Association of Certified Fraud Examiners (ACFE).

Whether fraud is committed through corruption, asset misappropriation (i.e., cash and non-cash larceny, skimming and fraudulent disbursements) or fraudulent statements, the law can be slow in keeping up with the newest schemes and prosecuting offenders, due in part to the fast pace of technological advancement. Deterring occupational fraud – challenging enough under normal economic conditions – is even more difficult for companies forced to impose recession-induced staff reductions, leaving them more exposed than usual to fraud.

The 2010 Global Fraud Study reported on occupational fraud cases in 2008 and 2009 involving over $18 billion in discovered losses. The study found that the median loss in financial statement frauds was $1.73 million, while corruption frauds and asset misappropriation frauds resulted in median losses of, respectively, $175,000 and $100,000 per scheme. While asset misappropriation was the least costly type of occupational fraud, it was the most common.

The study also reported that 31% of all occupational frauds were committed against small businesses having less than 100 employees. The median loss in those schemes was $155,000.

According to the ACFE, fraud perpetrators often display behavioral traits that serve as indicators of possible illegal behavior. The most commonly cited behavioral “red flags” were perpetrators living beyond their apparent means (43% of cases) and experiencing financial difficulties at the time of the frauds (36%). In financial statement fraud cases, which tend to be the most costly, excessive organizational pressure to perform was a particularly strong warning sign. Offenders included business partners, employees, contractors, vendors and outsiders who have found a way to gain internal access. Fraud experts suggest that anti-fraud deterrence policies include proactive measures to protect business assets from potential offenders.

Red Flags

Being alert to warning signs is one way to be proactive and identify fraudulent activity. Some of the most common red flags at the corporate level include:

• significant change in reported income or earnings;

• unreported business income;

• inappropriate accounting methods;

• investments with related parties;

• investments in unrelated assets and projects;

• lack of thorough employee screening;

• lack of separation of duties (purchasing, inventory, accounts payable, bank reconciliation, etc.);

• employees/partners with lavish spending habits (i.e., increase in trips/vacations – how are they financed); and

• employees/partners with financial difficulties and pressure.

These and other warning signs are often present for some time before an investigation is triggered. According to the ACFE study, the fraud typically lasts for 18 months before being detected.

Identifying Fraud Risk

In addition to the red flags, it is important to be aware of the personal circumstances of individuals placed in a position of trust within an organization. The recession has imposed extraordinary financial difficulties and pressure for perhaps the majority of people, and history has shown that devising fraudulent schemes is a predictable response by financially desperate people.

In a theory known as the ”fraud triangle,” white-collar criminologist Donald Cressey identified three elements that, together, create an increased likelihood that a trusted individual will commit fraud. According to Cressey, trusted individuals are more likely to commit fraud when they have all three elements of the fraud triangle:

• perceived need, typically from financial pressure;

• perceived opportunity; which presents itself when employees have been entrusted with funds or property and believe they will not be caught; and

• rationalization, when the fraudster views the fraudulent plan as non-criminal or justified, or as part of a general irresponsibility for which they are not accountable.

Because of the constant changes in the personal circumstances of trusted individuals, a proactive anti-fraud policy would include open lines of communication with these individuals, which may reduce the perceived opportunity element of the fraud triangle.

Professional Assistance

If financial fraud is suspected, an independent and certified fraud expert may be needed to perform a detailed forensic analysis. The scope of a forensic analysis may include some combination of the following:

• obtaining and examining documents;

• researching and verifying transactions and potential issues;

• interviewing involved parties (partners, employees, spouses, etc.) for potential issues;

• identifying all sources of income/funds;

• tracking all income and disbursements to identify unreported assets (cash, savings, trusts, brokerage, retirement, insurance, etc.);

• analyzing financial statement fluctuations;

• checking for indications of concealed assets;

• analyzing inventory control methods;

• analyzing expenses for hidden or misclassified transactions;

• analyzing disbursements for falsifications, forgery, larceny, skimming and other theft;

• performing a standard-of-living analysis on suspected fraudsters;

• quantifying damages/losses;

• assisting in developing and implementing anti-fraud policies;

• issuing an independent report detailing the forensic analysis and conclusion;

• providing litigation support; and

• assisting in the development and implementation of fraud prevention measures.

Regardless of the size of the company and the apparent trustworthiness of employees, business owners and employers seeking to minimize losses due to fraud must to be aware of risk factors, such as the elements of the fraud triangle, and watchful for any red flags that may help to identify and prevent fraud. ■