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The Realities of Fraud and Ways to Prevent It

To Jeff Haslow, CFO at hospitality solutions firm the Knowland Group, fraud is an issue that senior finance executives don’t discuss enough. It’s a taboo topic.

“I think anybody that’s been stung by fraud, they don’t really want to admit it,” Haslow says.

Haslow himself was stung, eight years ago, when he was working for a different company. An accounts-payable clerk was writing checks, recording the funds as paid to a vendor, and keeping the money. The clerk even intercepted bank statements from the mail to take out the cancelled checks.

“Eventually, controls caught up with the person,” Haslow says, and the company came up with a restitution plan to get back the $65,000 that had been stolen.

In this case, Haslow says, the thief was new to the company and didn’t understand that the misdeed would be caught when someone went through the bank statements and put the checks in order — and noticed a bunch were missing. But other companies are not so lucky, Haslow says. Some don’t have the appropriate controls that his did, and some face thieves who are in a position to do much more damage. Those thieves can include employees who have earned the trust of the company over a multi-year period and have received more control than they should have over the finances. According to risk management firm Kroll’s 2013/2014 Global Fraud Report, 16 percent of companies were affected by internal financial fraud in 2013, with just 12 percent reporting that problem in 2012.

More than a decade after Sarbanes-Oxley’s imposition on public companies and a spillover effect on privately held companies, issues surrounding controls are still a factor at many businesses, and fraud still occurs in high numbers. According to  the Kroll report, based on surveys of hundreds of senior executives from around the world, 70 percent of companies suffered at least one type of fraud in 2013. The average cost of each incident was 1.4 percent of the company’s revenue.

The Damage Done
By Kroll’s definition, fraud takes many forms. Physical theft accounted for the most incidents, 28 percent, followed by information theft, “management conflict of interest,” and fraud concerning a vendor, supplier, or procurement. A bit lower on the list were regulatory or compliance breaches, and corruption or bribery.

Not surprising, the higher fraudsters are on the corporate totem pole, the more damage they can do. The Association of Certified Fraud Examiners’ 2012 Report to the Nations found that fraud by rank-and-file employees typically costs companies $60,000 while owners or executives extracted $573,000 from their companies when they broke bad. The ACFE also found that asset misappropriation crimes like inventory theft and forged checks make up 87 percent of cases but typically cost companies $120,000. That figure is relatively low when considering financial statement fraud schemes make up only 8 percent of cases but have a typical price tag of $1 million.

Fortunately, some of the same methods can be used to address fraud at all levels, according to Jason Flemmons, former deputy chief accountant at the Securities and Exchange Commission’s Division of Enforcement. Flemmons, who now works as a senior managing director at advisory firm FTI Consulting and serves on the fraud task force for the American Institute of CPAs, says many companies need to shore up their internal controls.

Of course, many companies have done that. Thanks to Sarbanes-Oxley, public companies have been forced to formally analyze and certify the effectiveness of their internal controls. However, privately held companies aren’t held to the same standard, which could explain at least part of the reason why fraud is more common and typically involves larger total losses in private than public companies. With their more limited resources, small businesses also typically experience larger losses than big ones.

Step by Step
Flemmons says any company that wants to improve its fraud-prevention efforts should start by doing a “soup-to-nuts” risk assessment and brainstorm about possible gaps. Issues can include simple matters of employees’ duties, like ensuring that clerks can’t both calculate and post entries without getting approval and documenting what they did. The principle of segregation of duties can also guard against misdeeds at the highest level by making sure executives aren’t given the opportunity to swindle the company since they can’t cover their tracks in paperwork.

Any area involving judgment, like determining accounting reserves or valuing assets, should get special attention, Flemmons says. “All those things are very highly judgmental analyses and are very common areas for fraud.”

Another key vulnerability is the relationships between employees and suppliers or customers. Companies should be aware of the possibility of any unscrupulous partnership forming, to avoid any temptation of anyone wanting to create fake or inflated invoices. Flemmons says companies should be sure to have strong controls over approval and documentation of transactions to make sure they’re valid.

When controls aren’t enough and fraud does occur, managers and internal audit are the ones most likely to uncover the wrongdoing (in more than half of the cases, according to the Kroll study). Otherwise, a whistleblower may come forward: Employees who saw something and said something helped bring 32 percent of the cases to light in 2013, and in cases where middle or senior management was involved in the misdeeds, that percentage rose to 41 percent. External audits helped catch only 10 percent of the cases.

According to Harlow, these are key steps for minimizing fraud: Don’t give one trusted individual too much control over anything. Make sure multiple people are involved in various steps of making and recording transactions. Make sure everyone adheres to formal procedures.

And, he adds, it helps if there’s more open discussion about fraud, something he believes is starting to get more common. “I think we’re moving toward more of an awareness,” he says.


Livia Gershon is a freelance writer in Nashua, N.H.