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How to Spot Fraud There’s probably no ironclad way to prevent fraud in your company, but you may hold down your losses with proper management If you rely solely on outside auditors and fraud examiners to uncover your losses due to employee fraud, you may be closing the barn door after the horse has gone. A conventional audit may not reveal fraud, since most audits rely on sampling. If evidence of fraudulent transactions doesn’t make it into the sample, any isolated or ongoing instances of fraud may not be discovered and, as a result, may be allowed to continue. Even a forensic audit, in which typically every transaction is reviewed, is reactive in that it reveals what has already occurred and points to the responsible people and practices that have robbed your company of hard-earned profits. The persons who are best situated to take a proactive role in spotting and preventing fraud in your company are you and your employees – those who review transactions and maintain relationships with outside parties on a daily basis. Thus, effective management includes implementing and enforcing policies that hold each employee responsible for being aware of and responsible for preventing fraud in their area. Such policies include an attitude of zero tolerance toward fraud, with no "acceptable" level of loss due to theft, embezzlement or pilferage. Fraud consultant John J. Hall, writing in the October 1996 Journal of Accountancy, suggests that you and your managers follow a four-step approach to putting teeth in your fraud-prevention policies. Understand what can go wrong. Before you can create effective controls, you must consider what can go wrong in each area. This step is as difficult as it is essential, since white-collar thieves know more about their opportunities to commit fraud than you know about how to catch them. You may be aware of the potential for fraud via credit card misuse, fake vendors, inventory theft, kickbacks, bad loans, etc. But you probably don’t know, in specific detail, how to commit each type of fraud. Your crooked employees do. Re-examine your company’s experiences with fraud. Every type of business is more susceptible to certain forms of fraud than to others. If you have already detected fraud in your company, the smart money would be on the same or similar type of fraud attempted by someone else. Re-examine how past offenders did what they did, and recognize the position they held within the company. Involve in your current examination every department in your company that was involved in or exploited by past fraud; ask key employees in those departments to offer scenarios in which fraud could be committed. Ask them questions such as these:
After you have gathered feedback from your employees, take a fresh look at your controls. Take whatever steps are necessary to maximize their effectiveness, and instruct your employees about whom to contact if a transaction or report raises suspicion in their minds. Expand their scope to include detecting fraud, not just preventing it. Be alert to change. Even though you subsequently created controls designed to prevent history from repeating itself, be aware that changes in your company’s situation – downsizing, expansion, merger, outsourcing, automation, etc. – might render those controls obsolete. Further, while employees in fraud-sensitive positions may have a track record of integrity, be aware also that changes in their situation – financial hardship, divorce, stress, vices, etc. – can cause them to stray from their otherwise honest paths. Look it up. Researching your exposure to fraud has been made easier with the development of the Internet. Performing a search on "fraud" and related terms can make you more aware of how other companies have been defrauded and how you can learn from their less-than-positive experiences to improve your company’s internal controls. Look outside. You need not confine your research of fraud potential to your internal resources. Many trade organizations offer an excellent source of statistics, ideas and solutions that are specific to their industry. In addition, CPA firms, law firms and other professions that specialize in serving members of your industry can provide insight to help you anticipate problems. Recognize the symptoms. Even after you’ve been victimized by fraud, you may be slow to realize it and to take remedial action unless you’re alert to its symptoms, such as:
If one of the symptoms of fraud is present, look into it immediately. Be careful, though; it is very possible that everything is on the up-and-up, and you do not want to risk the legal and morale problems that can stem from unfairly accusing an innocent employee. If, on the other hand, evidence points to fraud, don’t hesitate to take appropriate action. If you find one bona fide instance of fraud, further investigation will probably turn up more. Reassign sensitive responsibilities as necessary to isolate the suspected employee from the potentially fraudulent situation. Then initiate your own investigation, or call in a fraud examiner to conduct it for you. Establish controls and audit procedures. Among the normal control procedures are (i) establishing quality control programs; (ii) sampling and retracing the work of employees who are in fraud-sensitive positions; (iii) reviewing unusual transactions; and (iv) requiring that all reconciliations receive an independent review. Ideally, you would segregate related financial and asset management functions – e.g., handling cash, preparing deposits, reconciling accounts, taking inventory — among two or more employees, so that no individual accumulates too much control. If segregation isn’t feasible, you should monitor those functions frequently, so that the employees who are responsible for those functions won’t begin to believe that they are free of accountability. If you lack confidence in your ability to establish proper controls, a CPA who regularly works with business clients should be able to point you in the right direction. No substitute for your own vigilance. Whether you create your own controls and conduct your own investigation or call on an outside professional, there are two responsibilities that you cannot effectively farm out: your day-to-day vigilance in watching what goes on in your company, and maintaining a healthy skepticism in holding your employees accountable for their actions. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
